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Friday
Feb262010

Are You Buying a Business or a Battle?


The local newspaper had a story Friday morning about former executives starting a new business that will compete with their former employer. Good for them! This is good news unless of course you are the party that just purchased the business that until recently employed these managers.

I know nothing about the purchase of the business, the resignation of the individuals or the launch of the new business. The legal implications of matters such as this are very fact specific. Without commenting on the current situation, there are lessons here for any potential purchaser of a business.

If you are purchasing a business, there are at least five ways you can avoid the loss of key employees that go on to compete with you. But first, let’s consider two questions.

Competition Issues?

When purchasing a business, what competition issues can arise? First, a former owner can start a new business or assist an existing competitor. Second, an employee of the business you purchase can leave to start a new business or work for another competitor.

The loss of customers is one concern. So is the loss of confidential information. If you are paying for customer lists, intellectual property, business methods or other business information not known to others, you do not want to lose what you purchased.

There are other concerns as well. You do not want someone that knows your new employees better than you do to recruit them to work somewhere else. Similarly, you want to protect your vendor relationships and the purchasing and pricing details with those vendors.

It is common for sellers of a business to sign noncompetition agreements. But what about key employees of the business?

Asset Purchase or Stock Purchase?

When purchasing a business, you can structure it as an asset purchase or an entity purchase. In an asset sale, you purchase the equipment, customer lists, inventories, contract rights and other assets of the business from the corporation, limited liability company or other business entity. Stated differently, you buy all of the corporation’s assets, you buy the business, but you do not buy the corporation’s stock.

The second type of transaction is where you buy the business entity. You buy the stock of the corporation. Or, you buy the ownership interests of a limited liability company. With the stock or the ownership interests comes all of the entity’s assets. That includes the business.

There are a number of reasons why you may prefer one sort of transaction over another. The type of purchase, asset purchase or stock purchase, will influence the tactics described below.

1. Noncompetition Due Diligence

As part of your due diligence investigation before purchase, you should identify key employees and the type of business information and business relationships they possess. Are each covered by valid, enforceable, noncompetition agreements? Have the agreements been reviewed by experienced legal counsel?

If there are one ore more key employees without a valid noncompetition agreement, you need to realize your transaction just became riskier. One or more key employees could leave taking valuable business information and business relationships with them. Accordingly, you may want to negotiate a lower purchase price to reflect this increased risk.

If your transaction is a stock or entity purchase, there must be valid agreements in place. You will not be able to get new noncompetition agreements under Oregon law unless there is a “bona-fide advancement.” If valid agreements do not cover all key employees, you may want to consider restructuring the transaction as an asset purchase. Other protections described below may also help.

If it is an asset purchase, you should certainly consider the following protections.

2. Assign Existing Agreements

If the transaction is an asset purchase and valid agreements are in place, make sure the seller specifically assigns those agreements to you as part of the asset purchase.

3. New Noncompetition Agreements

If one or more key employees are not covered by noncompetition agreements in an asset purchase, or even if they are, you can have all of your new key employees sign new noncompetition agreements. In doing so, you must follow the very specific requirements of Oregon’s noncompetition agreement statute.

This can work because the seller terminates all of the employees before closing. You hire all of the employees you want to keep after closing. Thus, you can argue the agreement was signed upon initial employment with you.

In your purchase agreement, you may want to list key employees by name and make your new noncompetition agreements with each of them a condition of purchase.

Remember, there are very specific requirements that must be followed before a noncompetition agreement is enforceable in Oregon. Extensive additional requirements were added in 2007. Other states have similar but different restrictions.

4. Nonsolicitation Agreements

Nonsolicitation agreements should be used together with noncompetition agreements. In a nonsolicitation agreement, the employee agrees not to solicit any of your current, former or prospective customers. It can also provide that the employee will not solicit any of your employees. Similarly, it can provide that the employee will not solicit any of your vendors or other strategic relationships you designate as well.

Generally, the rules for nonsolicitation agreements are different than for noncompetition agreements. Nonsolicitation agreements may be enforceable where noncompetition agreements are prohibited or are not valid.

A nonsolicitation agreement might be your best alternative in a stock or entity purchase when there are one or more key employees without valid noncompetition agreements.

The protections of a nonsolicitation agreement are different from a noncompetition agreement. Also, if you thought you were protected by a noncompetition agreement, but is later determined to be invalid, the nonsolicitation agreement can be an effective back up. For that reason, if you can, you should have key employees bound by both types of agreements.

Of course, if for one reason or another a noncompetition agreement is not an option, you should certainly require a nonsolicitation agreement.

5. Confidentiality Agreement

Protecting your confidential information is different than a noncompetition agreement or a nonsolicitation agreement. Even if an employee is allowed to compete or solicit customers or other business contacts, they are still under a legal obligation not to disclose your confidential information.

What is confidential information? It depends upon the business, but it certainly can include customer lists, price lists, vendor lists, cost information, marketing plans, business methods and processes, intellectual property, etc…

Rather than simply rely on the requirements set out in statutes and in court decisions, you can also require that employees sign confidential information agreements. The requirements for these agreements are different and less burdensome on employers than for noncompetition agreements.

Although a confidentiality agreement does not necessarily prevent an employee from competing, it can prevent the employee from using the information you purchased against you. In certain circumstances, where the risk of disclosure or improper use is high, courts can restrict the manner in which former employees might compete.

Where noncompetition agreements must be limited in duration, there is no such limit with confidential information. Nor should there be. Think of a company that has built a business on a secret formula. Coca-Cola for example. Should an employee with knowledge of the formula be able to use that formula or share it with another after a few years? Of course not.

Summary

If you are buying a business, you want to limit your surprises. You want an opportunity to realize the benefit of your bargain with the seller. You certainly do not want to have information you purchased going to a start up or established competitor. Identify key employees. Review the agreements with those key employees. Carefully analyze the validity of those agreements. Enter into new agreements as appropriate. Follow the state specific laws.

When purchasing a business, carefully protect its business relationships and business information. That way, you may avoid picking up the paper and realize you bought a battle when you thought you bought a business.

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