Acquiring goodwill is crucial when purchasing most businesses. But like anyone who has played a strategy game knows, taking something is easier than protecting it. That’s where restraints of trade come in.

But it isn’t that easy. Why? Because the law shoots down restraints unless they are reasonable in the parties’ and the public’s interest. Not getting shot down is where it becomes tricky.

What are restraints of trade?

Restraints protect an acquisition by prohibiting particular conduct by the seller (and sometimes key personnel of the seller) after completion. Generally speaking, restraints might prevent them from:

  • engaging in competitive business activities. This could prohibit the seller from manufacturing, distributing or selling products, or offering services that compete with the acquired business as at the completion date;
  • getting into bed with competitors. This aims to stop the seller from assisting competitors, including financially, by promoting competitors or by offering expertise;
  • having an interest in competitive businesses. This takes the prohibition against assisting competitors a notch higher by preventing the seller from having a proprietary interest in a competitive business, or even going so far as having an interest in the success of a competitive business.
  • poaching clients/customers. Depending on the acquired business, this could include restraints that prevent the solicitation of the clients/customers of the acquired business. This might extend beyond clients of the business at completion and for a specified period before completion. It might also work in conjunction with a restraint to prevent the seller from acting for or engaging those clients in a competitive business after completion;
  • disclosing or using confidential information, trade secrets or intellectual property. A seller who discloses or uses these assets could undercut or undermine the operation of the acquired business and the buyer’s standing in the market or industry;
  • obtaining information from key personnel or attempting to lure them away. Having regard to the importance and role of particular key or senior personnel in the acquired business, the seller might be prevented from interfering with their employment, enticing them to deliver information or to lure them into a competitive business.

What makes a restraint enforceable?

The important thing to understand is that the restraints imposed depend on the type of business and its sphere of operations. Investigation during the acquisition is key.

The short answer is: You can never be 100% sure.

That’s because while a court called upon to determine the validity of a restraint will give a good deal of weight to the fact that the parties have agreed on particular restraints, it is not bound by that agreement. The court will reach its own conclusion based on all the circumstances at the time that the parties entered into the restraints.

Step 1: Determining the buyer’s legitimate business interests

The first step in creating enforceable restraints requires an understanding of how a court might analyse the situation:

  • setting the boundary. Determining the business interests that the buyer should be entitled to protect by pinpointing the sources of goodwill and analysing the operations of the business (e.g. clients, IP, population density and trading areas);
  • staying within the boundary. Ensuring that the restraints go far enough only to protect those business interests because prohibitions that go beyond that reasonable protection may be unnecessary and therefore unreasonable and unenforceable;

Step 2: Understanding scope, space and time

Reasonableness lies at the heart of an enforceable restraint. Therefore, a restraint may be effective if:

  • scope. The seller’s or personnel’s prohibited conduct or activities is reasonable (e.g. it might not be reasonable to prevent a seller from investing in an international competitor that operates in different markets);
  • space. The geographical area where the restraint operates is reasonable (e.g. a restraint that fails to discriminate between areas that the acquired business does and does not operate might be unreasonable); and
  • time. The length of time that a restraint is imposed is reasonable (e.g. restraints that are unlimited in time will probably fail).

Step 3: Assuming that restraints will be put under a microscope

You cannot predict how a court will view a restraint. But you can minimise the risk of this known unknown by:

  • presenting alternative restraints. It is wise to provide alternative restraints, point out which restraints are to apply (or various combinations may apply separately until partly struck down), and which restraints should apply if some restraints fail. For example, if a time limitation of 3 years is held to be unreasonable, then there the separate periods of 18 months and 1 year might be included with a statement that they remain unaffected.
  • allowing offensive restraints to be severed. There should be a mechanism for allowing unreasonable restraints to be severed from the agreement to leave the reasonable restraints intact. Otherwise the entire restraint might fall apart, leaving the buyer with no protection.
  • being sincere in defining scope, space and time. The parties should genuinely try to define the appropriate protection and not just include lists of alternative restraints drafted mechanically. Do that, and the court may determine that the parties are asking the court to make their agreement for them. It will not do that. Instead the court may decide that the list is uncertain by having to independently choose a single restraint from a bunch of alternatives. Uncertainty has no place in a contract.
  • building the value of the restraint into the purchase price. A court will be more reluctant to find that a restraint is unreasonable if the result would be to allow the seller to keep all the sale proceeds without giving the buyer the benefit of the restraint component.
  • keeping negotiations fair. To the extent reasonably possible, the bargaining positions of the parties should be levelled by ensuring that each party is given the opportunity to obtain competent legal and financial advice. Alternatively, the superior party should not abuse its stronger position. This is a significant factor for the courts.
  • having a fall back position. If all else fails, there could be a procedure for calculating a sum of money to be paid by the seller to the buyer if the restraints are breached or are unenforceable. For example, a seller might be required to purchase the acquired business or part of it back from the buyer.

Investigation, fairness and competence

Restraints are delicate creatures in a business acquisition. And they can be one of the most important elements in the agreement.

Drafting them correctly requires investigation of the business, fairness and reasonableness in negotiations and competence in drafting. It is not to be compromised.