Restrictive Covenants in a Business Transaction

A restrictive covenant is also known as a negative covenant. It is an agreement or promise restricting the person or persons giving the covenant from taking certain actions.

In a business context, a restrictive covenant is a clause in a contract or agreement that works to prohibit an individual, or the seller of a company, from (among other things) competing with the prospective purchaser of the business for a certain period of time after the seller has left the business. This means restrictive covenants can affect parties before and after closing the deal.

For example, if a party is buying a business, they will want to prevent the seller from establishing a business that competes with their newly acquired business after the sale. In this instance, the buyer should provide for suitable restrictive covenants on the seller in the share/asset purchase agreement.

In some circumstances, the buyer may want to extend the restrictive covenant to the parent company of, or persons connected with the seller. Other examples of using a restrictive covenant could be to restrict the seller from:

• seeking existing customers or suppliers of the newly acquired business for a specified period;
• employing existing employees of the newly acquired business for a specified period; and
• competing generally with the newly acquired business within a specified geographical area for a specified period.

For a restrictive covenant to be enforceable, it must be reasonable and go no further than is necessary to protect the buyer’s legitimate business interests.

Restrictive covenants must be tailored exactly to the business that is being bought. The scope of the business must be defined carefully, and it should be noted that the courts may limit the time span for which restraints could be justified.

Restrictive covenants are difficult to draft, and their success is based on the reasonableness of what is being imposed. Ultimately, if a seller wishes to compete with the buyer’s newly bought business in the future, the buyer will need to issue proceedings to stop them from damaging their business which will involve time, cost, and effort. So, as to not fall at the first hurdle, prospective buyers should always impose restrictions what would be considered fair, and have legal advisers draft the provisions and agree them with the other side’s legal adviser.

If you or your business require information regarding anything in this blog or generally about your business or any other corporate matter, please call Sarah Ward, head of our corporate team, on 07889 589596 or e-mail Sarah at sward@georgegreen.co.uk for advice and assistance.