Restraint of trade clauses are common in an employment context, however they are also used when selling or buying a business. In this article, we’ll explain how restraint of trade clauses apply when selling a business.
Restraint of trade clauses generally
The two main types of restraints in restraint of trade clauses are:
- Non-compete clauses, which can restrict sellers in their further business ventures if they compete with the buyer; and
- Non-solicitation clauses, which can restrict sellers from poaching the staff, suppliers, clients, or any combination of people connected with the operation of the acquired business.
Restraint of trade clauses usually include limits to the operation of the restraints. These limits often specify that the restraints operate within a limited geographical area, and within a limited period of time. The clauses also usually contain cascading obligations. These are clauses that set out obligations in descending order of severity. For example, a clause might provide that a certain restraint operates for 24 months, 18 months, or 12 months.
Cascading and limits within restraint of trade clauses can help it survive a court dispute.
Restraint of trade clauses when selling a business
If you are buying or selling a business, your contract will often include a restraint of trade clause. Restraint of trade clauses apply when selling a business because they protect the buyer by securing the value of the business. Buyers will often try to use restraint of trade clauses to prevent sellers from starting a competing business nearby, or from poaching key staff members, suppliers, or clients. Since these restrictions can have quite a large impact on the potential business ventures of both the buyer and the seller, it is important for both potential buyers and sellers to know how restraint of trade clauses work, and the limits of their effectiveness.
This guide will examine how restraint of trade clauses work in the context of a sale of a business. If you are looking for how restraint of trade clauses work in employment contracts, try this guide instead.
Challenging a restraint of trade clause
Courts do not always enforce restraint of trade clauses.
In fact, the general rule is that courts will not enforce restraint of trade clauses unless the buyer can prove that the restrictions are reasonably necessary.
Whether a restraint is reasonably necessary depends on the nature and type of the business of the buyer acquired and the severity of the restrictions.
The assessment of severity may include:
- the nature of the restrained activities,
- the size of the geographical area that the prohibition applies to, and
- the duration of the prohibition.
Courts will enforce no more than what is reasonably necessary for protecting the legitimate business interests of the acquired business.
The rules and standards governing reasonableness may differ slightly from state to state. For example, New South Wales is the only state with legislation that regulates this.
If the buyer succeeds in proving that the clauses are reasonable, the court may enforce the restraint, ordering that the seller refrain from the prohibited action. The court may also award monetary compensation. If some of the clauses are unreasonable, the court may enforce the rest of the clauses while ignoring the unreasonable clauses. However, if all the clauses are unreasonable, then the court will not enforce any of the clauses. It is for this reason that writing the clauses in a cascading fashion is important.
Additionally, courts may decline enforcing a restraint of trade clause because it conflicts with a matter of public interest. The clause may also be invalid because of another reason in contract law.
So what should you do?
As always, it is important to consult a lawyer if you find yourself in a dispute. However, it is arguably more important, or at least more beneficial, to draft the restraint of trade clauses (and the rest of the clauses in the sale contract) well. You can see our contract template here. It is also important to consult a lawyer at this stage.
