Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Non-Compete Trap That Destroys M&A Seller Value
Transcript
- Lucas: So you sell your company for fifteen million dollars, walk away with a check, and then realize you can't start another business in the same space for five years. That's not hypothetical — I saw it happen to a SaaS founder last year. Luna: Wait — five years? I thought the standard non-compete in M&A was two, maybe three years tops? Lucas: That is the standard for a reason. But in that deal, the buyer pushed for five, and the seller — let's call him Mark — was so focused on the purchase price that he barely read the non-compete. He signed it, cashed out, and then spent eighteen months watching his former employees build a competitor under the new owner while he couldn't do anything. Luna: That's brutal. And it's exactly why this clause deserves its own episode. We've talked about earnout traps, indemnity baskets, working capital pegs — but the non-compete is the one restriction that follows you after the money hits your account. Lucas: Exactly. And the tricky part is, non-competes in M&A are almost always enforceable — much more so than employment non-competes. Courts view them as part of the sale of goodwill, which gives the buyer a legitimate business interest in restricting your future activity. Luna: Right, because the buyer paid for your customer relationships, your know-how, your brand. They don't want you to rebuild that overnight. Lucas: Precisely. But the problem is scope creep. A buyer might start with a reasonable three-year, limited-geography non-compete, and by the time the final draft lands, it's five years, nationwide, covering every product line you've ever touched. And if you're not careful, you sign away your ability to earn a living in the industry you built. Luna: So what are the specific dimensions we should watch out for? Duration, obviously. But also geography and scope of business? Lucas: Four dimensions, really. Duration, geography, scope of prohibited activities, and consideration — meaning, are you getting paid separately for the non-compete, or is it baked into the purchase price? I'd argue it should be separate, because a non-compete has real economic value. The IRS even has rules about allocating value to it. Luna: And duration — three years is standard for a mid-market deal. Anything beyond that, you'd better have a strong rationale. Five years is aggressive. Lucas: Yeah, and there's case law to back that up. In many states, a five-year non-compete in an M&A context is presumptively reasonable, but it can still be struck down if the scope is too broad. The key is to limit it to the specific business you sold — not 'any business the buyer might acquire in the future,' not 'any business in the technology sector.' That's a trap. Luna: I remember a case where a founder sold his e-commerce company, and the non-compete covered 'any online retail business.' He couldn't even launch a niche store selling handmade soaps because the buyer claimed it was online retail. He had to go to court. Lucas: Exactly the kind of thing we're talking about. So the scope needs to be tied to the products and services you sold, and the geography to where you actually operated. If you ran a regional HVAC company in Texas, a nationwide non-compete is overreach. A buyer might argue they plan to expand, but you negotiate from what the business was, not what it could become. Luna: And what about the 'blue pencil' doctrine? I've heard that term before. Lucas: The blue pencil doctrine allows a court to modify an overbroad non-compete rather than throw it out entirely. Some states, like Texas, embrace it. Others, like California, essentially ban non-competes altogether — but that's a different story. In a blue-pencil state, if you sign a five-year, nationwide non-compete, a court might reduce it to three years and one state. But you don't want to rely on litigation — you want to negotiate it right upfront. Luna: Let's talk about carve-outs. What can you ask for to protect yourself? Lucas: First, carve out your existing passive investments. You should be able to hold stock in public companies, or even private equity funds, without triggering the non-compete. Second, carve out consulting or advisory roles for non-competing businesses. Third — and this is a big one — carve out the right to start a new business in a different vertical or geography. Some buyers will allow a 'de minimis' exception, like up to five percent ownership in a competitor as a passive investor. Luna: And consideration. You mentioned that earlier. Should the non-compete be a separate line item in the deal? Lucas: It doesn't have to be, but it helps. The IRS has safe harbor rules — if you allocate part of the purchase price to a non-compete agreement, that amount is amortizable over its term for tax purposes. The seller recognizes it as ordinary income, but it's still a negotiation point. If the buyer insists on a five-year non-compete, you can say, 'Fine, but I want an additional $500,000 allocated to it.' That puts a price on what they're asking for. Luna: That changes the conversation. Suddenly the buyer has to justify whether that extra restriction is worth the extra cost. Lucas: Right. And if the non-compete is overly broad, it can also hurt the buyer's own tax position — the IRS might recharacterize the allocation if it's not realistic. So there's a mutual interest in keeping it reasonable. Luna: What about states that ban non-competes outright? California, North Dakota, Oklahoma — I think a few others. If you're selling a California-based company, can the buyer still enforce a non-compete? Lucas: California Business and Professions Code Section 16600 voids non-competes except in the sale of a business — and even then, the courts interpret it narrowly. The non-compete must be necessary to protect the buyer's legitimate interest in the goodwill they purchased. So a five-year, nationwide ban on all software development would almost certainly be struck down. But a two-year ban on developing a competing CRM product? That might hold. It's not a complete free-for-all. Luna: Good to know. So the takeaway: duration under three years, geography limited to where you did business, scope tied to the specific products or services you sold, and separate consideration if possible. Lucas: Plus, watch out for non-solicitation clauses buried in the same section. Sometimes the non-compete is reasonable, but the non-solicit says you can't hire any employee of the company for three years, or contact any customer. That can be even more restrictive than the non-compete itself. Luna: Absolutely. We did an episode on the non-solicit trap — episode 72, I think — and it's a classic companion to this one. Lucas: If this conversation has helped you think more clearly about your own deal terms, I'll mention something quickly. The reason we can dive deep into clauses like this without interruption is that the show is listener-supported. No ads, no sponsors. So if you find value in these episodes, you can support us at buy me a coffee dot com slash fexingo. It's a simple way to keep this resource going for other founders and operators. Luna: Yeah, and we appreciate that. It's what allows us to spend the time on niche topics like non-compete carve-outs rather than just surface-level advice. Lucas: Back to the negotiation tactics. One thing that works: ask the buyer to define 'competitive business' explicitly. If they say 'any business in the software industry,' push back by listing examples of what you might do post-close — starting a restaurant, investing in real estate, building a mobile app for a different vertical. Get them to agree in writing that those are not competitive. Put it in the definitive agreement. Luna: That's smart. And if they refuse, you know they're trying to lock you up more than they need to. Lucas: Exactly. Another tactic: include a 'right of first refusal' provision. If you want to start a new venture that might be arguably competitive, you have to give the buyer an opportunity to invest or license the technology first. That gives them a safety valve and can make them more comfortable with a narrower non-compete. Luna: Or you could ask for a 'carve-out for de minimis ownership' — like owning up to five percent of a publicly traded competitor. That's pretty standard. Lucas: Standard, yes, but still worth spelling out. I've seen deals where the non-compete said 'no ownership interest in any competitor,' and the seller had a small stake in a supplier that also competed indirectly. That created a dispute. Luna: So clarity is everything. Let's talk about enforcement risk. If you do sign an overbroad non-compete, what happens if you violate it — even unintentionally? Lucas: Worst case: the buyer can seek an injunction to stop you, and they can also sue for damages — which could be the amount they paid for the goodwill they claim you destroyed. Some non-competes include liquidated damages provisions, like a fixed dollar amount per violation. That can be huge. Luna: And legal fees. Most agreements say the prevailing party gets attorneys' fees. If you lose, you're on the hook for both sides. Lucas: Right. So the stakes are real. But here's the good news: in most M&A deals, the non-compete is negotiable. Buyers will push for as much as they can get, but if you have a good attorney and you understand the dimensions, you can push back. I've seen sellers successfully reduce a five-year non-compete to three, shrink a nationwide scope to three states, and carve out entire product categories. Luna: What about the seller who wants to stay on as an employee post-close? Does a non-compete still apply? Lucas: Usually, the non-compete is separate from the employment agreement. If you stay on as an employee, you might have an additional employee non-compete, but the M&A non-compete typically starts at closing. One key point: if you become an employee, the non-compete might be less enforceable because employment non-competes face stricter scrutiny in many states. So if you're staying, you might be able to negotiate a 'sunset' provision — the non-compete ends when your employment ends. Luna: That's a great angle. I think a lot of sellers don't realize they can negotiate the non-compete separately from the employment terms. Lucas: Right. And finally, consider the 'garden leave' concept. In some deals, the seller agrees to a non-compete for a period, but the buyer pays them a salary during that time. That's more common in financial services, but it can be adapted. It makes the restriction feel less punitive. Luna: Alright, so let's recap for someone getting ready to sell: keep duration to three years max, limit geography to your actual market, scope to the products you sold, carve out passive investments and consulting, allocate separate consideration, define 'competitive business' clearly, and watch for non-solicit traps. Lucas: That's a solid checklist. And one more thing: get everything in writing. Verbal assurances from the buyer that they won't enforce the non-compete broadly are worthless. If it's not in the agreement, it doesn't exist. Luna: Great point. Lucas, thanks for walking through this. I think a lot of our listeners are going to pull up their own agreements and check after this episode. Lucas: That's the goal. If just one seller avoids the trap Mark fell into, we've done our job. Next episode, we'll look at another clause that often gets overlooked — the 'most favored nation' provision in M&A deals. That one can cost you millions if you're not careful. Luna: Looking forward to it. Until then, keep your eyes on the fine print.