Case Study - Showing Restraint in a Sale of Business

Posted by Malcolm Campbell on 21 November 2018
Case Study  - Showing Restraint in a Sale of Business

Further to our recent blog regarding the vital importance of ensuring that appropriate restraints are put in place upon a vendor selling a business, we recently acted for a purchaser in a sale of business matter where this very issue arose.

Our client already operated their own business and was seeking to acquire a competitor as a part of their growth strategy.  Both our client and the vendor of the competing business operated their respective businesses through company structures.

As typically happens, our client had negotiated the ‘headline’ terms of the deal (such as price and timing) directly with the Vendor before engaging our services.  We were engaged at the point in time that the Vendor's lawyers had provided the draft contract and other related documents for the transaction.  The transaction was for a total value of close to $10 million.

In this instance, the Vendor's lawyers chose not to use the Law Society standard Contract for Sale of Business but rather their own bespoke document.  This document did not contain restraint of trade provisions.  

As part of the deal it had been agreed between the parties that the director of the Vendor would work in the business being acquired by our client for a minimum period of one year.  It had not been expressed by either party whether this would be in the capacity of an employee or as an independent contractor.

However, the documents supplied by the Vendor's lawyers did not include either an employment agreement or an independent contractors agreement.  After requesting the provision of both a Deed of Restraint and an agreement regarding the engagement of the Vendor's director by our client, we eventually received both documents.  Unfortunately, neither the Deed of Restraint nor the Independent Contractors Agreement contained provisions that restrained the vendor’s directors from competing with the business being acquired by our client.

Accordingly, we requested that both the Deed of Restraint in relation to the sale of business and the Independent Contractors Agreement in relation to the ongoing provision of services from one of the Vendor's directors be amended to include restraint provisions that covered the vendor company and both of the directors.  

An amended Deed and Contract that appropriately restrained the vendor company and each of their directors from competing with the business for a defined period of time within a specific geographic location was subsequently received from the Vendor's lawyers.  This gave our client confidence that they would be able to extract the full value of the goodwill that they were acquiring from the vendor without the risk of it being watered down or devalued by interference (whether deliberate or innocent) by the Vendor and/or their directors.  The transaction proceeded in the ordinary course until the day of settlement.

On the morning of the date for settlement of the transaction, we were notified by the Vendor's lawyer that their clients would not be entering into the Deed of Restraint or the Independent Contractors Agreement as they felt that the restraints within them unreasonably restricted them from earning an income.  This was despite the fact that it was the Vendor's lawyers who had prepared and then amended those documents.

The proposed amendments to the restraints which were put forward on the morning of the settlement on behalf of the Vendor were completely unacceptable to our client.  Unsurprisingly, settlement did not proceed on the due date, much to the extreme frustration of our client who had made all of the necessary arrangements to commence their takeover of the business on that date at great cost and inconvenience to them.

After weeks of further negotiations that seemed to be unable to progress in a satisfactory manner to either party, a round table conference was organised with all directors of the vendor and the purchaser and their lawyers.  After a five hour conference, the parties were eventually able to agree on suitable and appropriate restraints.

As is the case in all negotiations, both parties had to give some ground but the restraints that were ultimately achieved were appropriate for our client in all the circumstances. The key issue which became evident during the marathon conference was that the Vendor's directors had little to no idea about the meaning of the clauses which had been prepared by their lawyer.  Either their lawyer had not advised them on these matters, or the clients had not understood the advice and practical implications of it at least until the morning of the original settlement date.

The Vendor’s directors genuinely believed at the commencement of the conference that it was entirely fair and reasonable that they receive a large payment for the business that they were selling and that they would immediately be free to work as employees or independent contractors within the very same industry in the same locality. They took the view that, because they were no longer business owners per se, they did not pose a risk to our client.  Obviously our client did not take the same view.

The Vendor's directors approach to the matter failed to take into account the influence that they could have with clients, suppliers and competitors alike, simply by them being active in the same market whether they were actively trying to compete or not.  Further, there was much debate about whether or not the restraints should start from the date of completion of the sale or at a later date when the Independent Contractors Agreement came to an end.

Ultimately the parties were able to resolve the matter and the transaction finalised.  Thankfully, the client is happy and is successfully expanding their business in accordance with their original plans. However, many weeks of extreme stress and anxiety and significantly increased legal costs could have been avoided had these matters being properly considered by the parties during their initial discussions and the vendor's lawyers providing full and detailed advice (together with confirming their client fully understood) as to the likelihood and practicalities of post-sale restraints.

We have assisted thousands of businesses over our 21 years of operation by providing clarity and confidence in their legal relationships.  If you'd like to know a little bit more about the important issues to consider when buying or selling a business, download a free copy of our e-book here.