Covenants Not to Compete in the Sale of a Business: Protecting Goodwill

• Publication year: 1997
• Pages: 31

26 Colo.Law. 31 Colorado Lawyer 1997.

1997, December, Pg. 31. Covenants Not to Compete in the Sale of a Business: Protecting Goodwill

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31

Vol.26, No. 11, Pg. 31

The Colorado Lawyer
December 1997
Vol. 26, No. 12 [Page 31]

Specialty Law Columns
Business Law Newsletter
Covenants Not to Compete in the Sale of a Business Protecting Goodwill
by Jon-Mark C. Patterson, Joel M. Funk

A buyer purchasing substantially all of the stock or assets of a going business buys more than just hard assets. The buyer acquires a business that is up and running, with a whole that is generally greater than the sum of its parts. In most cases, substantial value exists in the business's base of established customers, reputation, and routines. The value of this "goodwill" is a significant part of what the seller offers, and the purchase price will generally reflect an appropriate allocation.1

Covenants not to compete protect the value of goodwill Consider this situation: what if a seller, after the sale enters the business premises and removes the equipment, inventory, or fixtures just sold to the buyer? This would be an unfair reappropriation of property. Now consider another situation: the seller opens up a new business near the business just sold, uses a similar name, and advertises to former customers. In this situation, the seller is trying to appropriate the goodwill of the business. The seller is, in effect, taking back a valuable asset sold to the buyer.

To avoid these problems, a prudent business lawyer will counsel the buyer to require a covenant that limits the seller's rights to compete with the buyer after the sale. This article discusses the legal bases for, and some practical issues in, drafting and enforcing covenants not to compete.

Statutory Framework In Colorado

As a general rule, Colorado law prohibits covenants not to compete as unlawful restraints of trade. However, a Colorado statute enacted in 19732 follows the common law in allowing covenants incident to the purchase and sale of a business.3 CRS § 8-2-113(2) states:

Any covenant not to compete which restricts the right of any person to receive compensation for performance of skilled or unskilled labor for any employer shall be void, but this subsection (2) shall not apply to:

(a) Any contract for the purchase and sale of a business or the assets of a business[.]

Common Law Basis for CRS § 8-2-113

In 1913, the Colorado Supreme Court announced the doctrine that was later codified in CRS § 8-2-113(2)(a). In Barrows v. McMurtry Manufacturing Co.,4 the court affirmed an injunction entered to enforce a covenant not to engage in, invest in, or be employed by any business selling paint and glass for ten years throughout Colorado.5

The Barrows court identified several factors in its decision:

1) the right to contract is fundamental;

2) goodwill from a profession, trade, or business is property deserving protection, and it is unjust to permit the seller to regain possession of what the seller has sold;

3) contracts made to protect purchasers should be strictly enforced if they are reasonable, and may be modified to be enforceable if they were unreasonable as originally written;

4) because goodwill is the consideration for the covenant, the scope and duration of the covenant must be no greater than necessary to protect the value of the goodwill.6

In support of its conclusion, the court cited the 1909 case of Freudenthal v. Espey,7 which first announced the rule that reasonable covenants not to compete were valid and enforceable in Colorado, and which upheld a five-year covenant not to compete in providing medical services.8 The Freudenthal court set out a two-part test for assessing the validity of a covenant not to compete. First, there must be consideration for the covenant.9 Second, the covenant must be reasonable. A reasonable covenant gives fair protection to the buyer, given the nature and extent of the business and the situation of the parties, but does not interfere with the interests of the public.10

In dicta, the Freudenthal court noted that there is a qualitative difference between covenants not to compete that hinder the "practice of a learned profession" and those incident to protecting goodwill after the sale of a business. While the former should be limited in time, covenants not to compete in the sale of a business context could include an "indefinite" restraint.11 The Barrows requirement--that the need to protect the goodwill is the measure of the reasonableness of the covenant--presumably sets some limit on the permissible duration and extent of such covenants.

Modern Law: Purposes And Enforceability

Modern Colorado decisions adopt the traditional Barrows and Freudenthal rationale that goodwill is a valuable asset, and that reasonable covenants not to compete are necessary to protect the interests of a buyer.12 Reasonable covenants not to compete also protect the interests of a seller because that seller may fairly demand a higher price for a business which includes protectable goodwill.

The "reasonable" requirement necessitates a fact-specific determination of "whether the covenant provides a fair protection to the interests of the purchasing party in reasonably protecting what he bought."13 As with most determinations of "reasonableness," there is no bright-line rule.

In the employment context, Colorado courts have held that a covenant not to compete must be reasonable in...