The Impact of Noncompete Laws on Private Equity Transactions and Talent Strategies

Noncompete agreements, a type of restrictive covenant, have long been used to protect proprietary assets such as goodwill, customer relationships, employee relationships, trade secrets, and other confidential information. In jurisdictions and contexts where noncompetes are generally permissible, they still must satisfy certain scope and other requirements to be enforceable. What those requirements encompass can vary significantly by jurisdiction and by the context in which the noncompete is entered.

To add to this complexity, private equity practitioners must remain cognizant that noncompete laws are shifting and evolving in real time across various jurisdictions. This fluctuating landscape has the potential to adversely or unexpectedly impact deal terms, employment provisions, and workforce planning.

Below we highlight some recent judicial and regulatory noncompete developments to keep in mind in the context of private equity transactions.

A SHIFTING REGULATORY PATCHWORK

In the United States, the Federal Trade Commission’s recent rule banning noncompetes remains tied up in court, with its enforcement currently enjoined. Expectations are that the current US administration will abandon defense of the rule to instead focus on individual enforcement actions. 

In the interim, several states have moved to adopt new or expanded legislation around noncompetes. The result has been a growing divergence in how these restrictive covenants are regulated at the US state level. Some states, such as Minnesota, Oklahoma, and North Dakota, have joined California in effectively banning noncompetes, subject to limited exceptions. Other states, including Kansas and Florida, have gone the opposite direction, adopting legislation making it easier to enforce noncompetes.

Florida’s new CHOICE Act, for example, expands the permissible duration of noncompetes to up to four years and requires that a court issue a preliminary injunction simply upon motion by a covered employer seeking enforcement of a covered agreement.

Meanwhile, outside of the United States, common themes align with US principles but vary in execution. Many countries impose specific statutory requirements. In Europe, aside from the UK and Switzerland, enforceability can often require ongoing compensation payments. In other jurisdictions, such as Colombia, India, Malaysia, Mexico, and Ontario, noncompetes are banned or heavily restricted. Another departure from US law and practice is that many non-US jurisdictions rely on financial penalties—not injunctions—as remedies for breach of noncompetes.

The takeaway from this shifting patchwork of laws, and large variation in what is permissible in different jurisdictions, is that it is crucial to identify in private equity transactions what noncompete laws will apply and consult with noncompete experts to ensure enforceability, reduce exposure, and avoid unexpected results.

SALE OF BUSINESS AND EQUITY-BASED NONCOMPETES

Sale- and equity-based noncompetes, focused on protecting goodwill, are typically more enforceable subject to nuances around materiality, scope of the protected business interest, and details regarding geography and duration.

Some recent developments to note include the following:

• Auction NDAs now regularly include nonsolicits of employees, and we have observed that the market practice in this area has been to increase the reach and duration of these restrictive covenants. Private equity professionals should note that these agreements have antitrust law implications; a potential buyer signing up to such a restrictive covenant could be exposing itself to liability.
• Many states have adopted statutes that cap noncompete temporal durations. Colorado has taken a unique approach, setting a formula to calculate the permissive duration of noncompetes for individual minority owners in the sale-of-business context: the maximum duration of a noncompete is determined by the consideration the individual received from the sale divided by the average annual cash compensation received by the individual from the business (including income received on account of their ownership interest) during the prior two years or the period the individual was affiliated with the business if shorter.
• The Delaware Supreme Court has recently weighed in on forfeiture-for-competition provisions, finding that these provisions, which do not enjoin competition but rather require forfeiture of certain enumerated benefits (whether compensation or equity), are enforceable if they satisfy standard contract law principles and are not subject to the more rigorous “reasonableness” test that applies to traditional noncompetes.
• On the other hand, the Delaware Court of Chancery recently questioned, in striking down a noncompete, the adequacy of consideration to support a noncompete in certain equity-based noncompete contexts, albeit many practitioners would consider this a departure from historical and expected interpretations of the law (and so it is unclear as to whether this decision will be followed in future cases). In another case, the Delaware chancery court declined to reform and enforce what it deemed to be an overly broad noncompete.
• California recently adopted anti-noncompete legislation that purports to extend with a broad reach across jurisdictions if there is some connection to California. Recent cases in non-California jurisdictions have severely limited this “long-arm” aspect of the law, finding it not enforceable in respect of agreements entered into outside of California. It remains to be seen how a California court might rule in a similar case brought inside of the state.

CONCLUSION

Trusted legal counsel can guide private equity professionals through this rapidly evolving noncompete environment, assessing and mitigating potential risks, and ensuring compliance in the face of these complex and changing laws and regulations.