Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Non-Compete Clause That Cost a Seller 26 Million
Transcript
- Lucas: So there's a deal that closed about eighteen months ago, a logistics software company sold for one hundred twenty million dollars. And the founder, a guy named Daniel, walked away with a twenty-six million dollar earnout. He didn't collect a cent of it. And it wasn't because the company missed its numbers. It was because of a non-compete clause he signed without really reading. Luna: That's a brutal headline. How do you lose an earnout because of a non-compete? Lucas: Well, the earnout was tied to the company hitting a certain revenue target in year two. And it did, actually. But the buyer refused to pay, arguing that Daniel had breached the non-compete by consulting for a small supply chain startup. The non-compete said he couldn't engage in any business that was 'in any way related to logistics software.' That's the language. And the startup was building a route optimization tool for local delivery. It had nothing to do with the company's enterprise software. But the buyer's lawyers argued it was 'related.' Luna: So the buyer used the non-compete as a weapon to avoid paying the earnout. That seems... cynical. Lucas: Cynical, but effective. Daniel spent six months and probably three hundred thousand dollars in legal fees fighting the claim. He eventually settled for a fraction of the earnout. But look, the real story isn't the dispute. It's that Daniel signed a non-compete that was way too broad. And he's not alone. I've seen sellers sign covenants that ban them from their entire industry for ten years, or that don't carve out passive investments. It's one of the most under-negotiated clauses in a purchase agreement. Luna: Why is that? You'd think a founder would care about what they can do after they sell. Lucas: You'd think so. But by the time you're signing the deal, you're exhausted. You've been through months of due diligence, you're emotionally checked out, and the non-compete is buried on page forty of a two-hundred-page purchase agreement. The buyer's lawyer presents it as boilerplate. 'This is standard,' they say. And the seller just signs. Luna: So what should a seller actually look for? What's a fair non-compete? Lucas: Let's break it into three dimensions. The period, the geography, and the scope of business activity. On the period, three years is typical for a business sale. Five is aggressive. Seven, like Daniel got stuck with, is really pushing it. On geography, it should be tied to where the company actually operates. If you sold a regional business in the Pacific Northwest, you shouldn't be barred from opening a similar business in Texas. And on scope, the definition of the restricted business should be specific, not 'any way related.' Luna: But isn't there a tension there? The buyer wants to protect the goodwill they just paid for. If the seller starts a similar business across the street, that's a problem. Lucas: Exactly. The buyer has a legitimate interest. They paid for the customer relationships, the trade secrets, the know-how. So the non-compete should protect that. But it shouldn't prevent the seller from making a living in their field. The key is to focus on what the seller actually takes with them. If Daniel had negotiated a carve-out for consulting that doesn't involve the company's core technology, he would have been fine. Luna: So what's a specific carve-out that works? Something a seller could ask for. Lucas: A few things. First, a carve-out for passive investments. So you can own up to five percent of a public company in the same industry. That's pretty standard. Second, a carve-out for consulting or advisory work that doesn't compete directly with the sold business. And third, a list of specific activities that are allowed. You can literally attach a schedule to the non-compete: 'This covenant does not prohibit the seller from providing consulting services to non-competing companies.' That kind of clarity saves a lot of pain. Luna: And what about the earnout? Should the non-compete and the earnout be linked? Lucas: That's a great question, and it's where Daniel really got burned. In many deals, the non-compete and the earnout are separate. The buyer can enforce the non-compete even if it kills the earnout. So a seller should try to negotiate that any breach of the non-compete only affects the earnout if it actually causes harm to the business. If the buyer can't show that Daniel's consulting cost them revenue, then the earnout should still be paid. Luna: That seems fair. But does a buyer ever agree to that? Lucas: Sometimes, if you ask. The easier path is to add a liquidated damages clause. That means if the seller breaches the non-compete, they owe a fixed amount, say ten percent of the purchase price. That gives the buyer certainty and the seller a cap. Daniel's contract didn't have that, so the damages were whatever the buyer claimed, which was the entire twenty-six million dollar earnout. Luna: So what should a seller do if they're already in a deal and the buyer hands them a non-compete they don't like? Lucas: First, don't sign that day. Ask for time to review it with your own lawyer. Second, push back on the specific language. Say 'I need the scope to be more precise.' And third, consider the tail. After the non-compete expires, can you go back to the industry? Daniel's was seven years. That's a huge chunk of his earning life. Luna: It's almost like the non-compete is a second sale. You're selling your future too, not just the company. Lucas: That's exactly the right way to think about it. You're not just selling an asset; you're selling your ability to compete. And that has real value. In fact, there's a legal principle called 'the covenant of good faith and fair dealing,' but it doesn't always protect sellers in practice. The contract language is what matters. Luna: And that language is often written by the buyer's lawyer, who doesn't care about your future. Lucas: Right. So you have to bring your own lawyer who does. And ideally someone who specializes in M&A, not just a general practitioner. I've seen sellers save millions just by having a lawyer who knows how to push back on these clauses. Luna: Let's talk about the psychology for a moment. Why do founders like Daniel agree to such restrictive covenants in the first place? Lucas: Part of it is the asymmetry of information. The buyer's team runs this play all the time. They know exactly which clauses are negotiable and which aren't. The seller is doing this once, maybe twice in a lifetime. So they're at a disadvantage from the start. And there's also the emotional factor. You've spent years building this company, and now you want to close the deal. You don't want to be the one holding things up over a clause you don't fully understand. Luna: That's where the buyer can leverage that impatience. Lucas: Absolutely. There's a famous saying in deal-making: 'The party with more time wins.' The buyer can afford to wait; the seller usually can't. So when the buyer says 'this is our final offer on the non-compete,' the seller is tempted to cave. But that's exactly when you should step back and ask for a day to think about it. Luna: And what about the buyer's perspective? Are there any risks for them in a poorly drafted non-compete? Lucas: Funny you should mention that. A non-compete that's too broad can be unenforceable in court. Courts in many states will strike down an unreasonable restriction entirely, not just narrow it. So the buyer who insists on a seven-year, nationwide ban might end up with nothing. A well-tailored restriction is more likely to hold up, which actually protects the buyer's purchase. Luna: So it's in both parties' interest to be reasonable, but they still end up fighting. Lucas: That's the paradox of M&A. Everyone wants a smooth closing, but the negotiation is where each side tries to shift risk to the other. And the non-compete is a classic risk-shifting tool. The buyer wants to lock up the seller's future. The seller wants to keep their options open. Without clear language, you get disputes like Daniel's. Luna: And Daniel's dispute cost him twenty-six million dollars. That's a hard lesson. What's the takeaway for our listeners who might be selling a business in the next few years? Lucas: Three things. One, treat the non-compete as seriously as the purchase price. It's a real asset you're giving up. Two, get specific. Define the period, geography, and scope in concrete terms. And three, consider how it interacts with the earnout. If you have an earnout, make sure a breach of the non-compete only kills it if it actually hurts the business. That's the clause that would have saved Daniel. Luna: And maybe add that liquidated damages clause to avoid the nuclear option. Lucas: Exactly. A fixed amount is better than an open-ended claim. Speaking of which, I was thinking about this the other day. We spend a lot of time on this show talking about the clauses that cost people millions. And I think the reason we do it is because these lessons are so valuable. If even one listener avoids a trap because of something we said, that's worth more than any ad revenue. Luna: You know, that's actually something I've thought about too. This show is ad-free, and that's a deliberate choice. And the only reason we can keep it that way is because of listeners who support us directly. Lucas: Right. So if these conversations have moved your work forward in some small way, and you want to help us keep doing this, you can support the show at buy me a coffee dot com slash fexingo. It's a simple gesture, but it genuinely keeps the lights on. Luna: And it keeps us independent, which means we can tell stories like Daniel's without pulling punches. Lucas: Yeah. And speaking of pulling punches, let's go back to that non-compete. I want to give you a specific example of a carve-out that works. I was involved in a deal a few years back where the seller was a dermatologist who sold her practice. The non-compete barred her from practicing within a fifty-mile radius for three years. But we negotiated a carve-out that allowed her to do telemedicine consultations for patients outside that radius. That preserved her income and didn't compete with the practice. Luna: That's a smart carve-out. It shows that with a little creativity, both sides can get what they need. Lucas: Exactly. And that's the mindset to bring into the negotiation. Not 'how do I get out of this,' but 'how do I define this so it's fair to both of us.' That's how you protect the deal and your future. Luna: So, next time you're handed a non-compete, don't just sign. Ask yourself: what am I really giving up? And what could it cost me if I don't push back? Lucas: And remember Daniel. He thought he was selling his company for a hundred and twenty million. In the end, he gave up twenty-six million of it because of a clause he didn't read. That's the real acquisition talk.