Examining restrictive covenants in M&A

June 2025  |  FEATURE | MERGERS & ACQUISITIONS

Financier Worldwide Magazine

June 2025 Issue

Mergers and acquisitions are full of potential pitfalls. To ensure a successful journey, both parties must take proactive measures to mitigate risks and safeguard the deal’s value for the future. Among the strategies available, one of the most intriguing and complex is the use of restrictive covenants. These legal agreements can play a pivotal role in protecting interests and ensuring smooth transitions.

Covenants in M&A transactions serve as enforceable promises to either do something (positive covenants) or not do something (restrictive covenants) that will impact the company or the sale.

Restrictive covenants, primarily in the form of non-competition and non-solicitation agreements or provisions, are customarily included in M&A transactions. In most M&A transactions, the purchaser usually requires the seller to sign up to a number of restrictive covenants under the share & purchase agreement (SPA). These promises, typically made by the seller, protect the buyer before and after the deal closes.

Such covenants prevent the seller from engaging in or working for a competitive business that could undermine the goodwill and expertise of the newly acquired entity. Buyers typically restrict sellers from starting a competing business or joining a competitor after the transaction closes. From an M&A perspective, these covenants protect the target’s goodwill and prevent the seller from competing with the target for a specified period following completion.

Also, M&A transactions are increasingly structured around retaining key individuals at the target business, particularly for their skills and contacts, to help sustain the success and growth of the business after completion.

Typical restrictions include: (i) non-compete clauses, which prevent the seller from engaging in activities that compete with the business being sold; (ii) non-solicitation clauses, which stop the seller from seeking business from specific or potential clients or customers; (iii) non-dealing clauses, which prevent the seller from having any dealings with clients and customers; (iv) non-poaching agreements, which prevent the seller from employing, engaging or enticing certain colleagues to join a competing business; and (v) non-interference clauses, which prevent the seller from seeking to divert supplier relationships away from their business that has been sold.

Rather than simply drafting restrictive covenants with boilerplate language, they can be used strategically when negotiating the purchase agreement. But M&A advisers must differentiate between the legal principles governing restrictive covenants in employment contracts and those in M&A transactions. Failing to do so could result in missed opportunities to maximise value during negotiations.

Different jurisdictions take different approaches to restrictive covenants. In the UK, for example, a large body of case law on restrictive covenants has established that any post-termination restrictions that go further than ‘reasonably’ necessary to protect a ‘legitimate business interest’ will be void and unenforceable because they restrain trade. For that reason, non-solicitation of employees’ covenants are often limited in scope to ‘key employees’ only.

Additionally, the geographical scope of the covenants is often quite narrow, and they are unlikely to be given for a period exceeding three years. Depending on the circumstances of the business being sold and what may be considered ‘reasonable’ in the circumstances, any longer-term provisions are likely to be unenforceable.

In the US, by contrast, post-closing covenants typically include agreements not to solicit clients, customers, suppliers or employees of the target, as well as a non-compete covenant and a confidentiality provision. Non-solicitation covenants usually cover a period of one to two years, while the non-compete covenant typically lasts between three and five years.

In April 2024, the approach to restrictive covenants changed when the US Federal Trade Commission (FTC) announced a nationwide ban on non-compete clauses and published a final rule. The rule imposes a national ban on all employers from using non-compete clauses in contracts with workers at any level (subject to certain exceptions). Notably, in the M&A context, there is an exception that permits non-competes entered into in connection with a ‘bona fide sale of a business’. However, the future of the final rule is uncertain as it faces strong statutory and constitutional challenges which may delay the effective date. The current Trump administration is not expected to introduce further measures to restrict non-competes.

Restrictive covenants are undeniably crucial in any M&A transaction, serving as formal agreements essential for preserving the value of a target company after the deal closes. These covenants, both restrictive and positive, are just one element among the many that comprise the purchase agreement and the overall M&A transaction. Recognising their importance helps both acquirers and targets better navigate the complexities of the deal.

© Financier Worldwide

BY

Richard Summerfield