Shoot the Moon with Revenue Rocket

Master Non-Competes in IT M&A: Protect Your Deal

Episode Summary

Matt Lockhart and Ryan Barnett discuss the importance of non-compete and non-solicitation clauses in M&A deals for tech services companies. Non-competes protect buyers' interests by preventing sellers from using their knowledge and relationships to compete. Duration can range from one to five years, with shareholder agreements often lasting five years. Scope should be specified to avoid overly broad restrictions. Enforceability varies by state. Non-solicitation clauses protect against employee poaching. Consideration for non-competes can include cash. Sellers should carefully review these clauses with legal counsel to ensure they are market-standard and not overly restrictive.

Episode Notes

🎙️ 1. What’s the real purpose of a non-compete clause in an M&A deal?

 

🎙️ 2. How long and how broad should a typical non-compete be in IT services M&A?

 

🎙️ 3. What’s the difference between a non-compete and a non-solicit clause?

 

🎙️ 4. Are non-competes really enforceable? Or do some states or countries treat them as worthless?

 

🎙️ 5. What’s the risk of agreeing to a non-compete that’s too broad?

 

🎙️ 6. How can sellers negotiate a more balanced non-compete clause?

 

🎙️ 7. What’s one of the biggest mistakes you see sellers make when reviewing these clauses?

Episode Transcription

Matt Lockhart 0:00: Hello and welcome to this week's episode of the shoot the moon podcast. Brought to you by Revenue Rocket. For those of you who may be new Revenue Rocket is the world's premier M&A advisor and growth strategy advisor for tech enabled services worldwide. I'm with my partner in crime, Ryan Barnett, our fearless leader, Mike is out again today, but looks forward to getting back next week, Ryan, how are you doing? 

Ryan Barnett 0:42 Hey, Matt, I'm doing great. And thank you so much for joining here today. We are really focused on issues that are fairly down the pipe in mergers and acquisition work for IT services companies. So if you're an MSP or a CSP, or your application developer and someone in the tech services space, and you're trying to understand what this market is like. The shoot to win podcast is for you today, we are talking about something a little bit long tail, but it is something important, which is non compete and non solicitation clauses that you might see within all sorts of legal agreements in the M&A process, we can see them as as early as letters of intent. We've seen them even almost non disclosure agreements. I think you have some clauses related to that, but Matt, help me understand and just get me going. What is the purpose of a non compete clause in any kind of M&A deal? 

Matt Lockhart 1:46 Yeah, Ryan, a great question for sure, and and non competes, non solicitation is, is absolutely a critical part of the overall legal agreements between, you know, buyers and sellers. You know, obviously, from a buyer perspective, the buyer is trying to protect their interest as well as protect their business. So the interest in buying a new business and and their existing business and ensuring that there is adequate coverage that a seller is is not going to use his knowledge, his past relationships, to To compete in the like services that the buyer is, is, is, is interested in, you know, so it's it, it sort of sets the framework, if you will, that the buyer has adequate protection related to customers, to employees, to contracts. And those three are, I think, the majority of protection important again, that there's things that are typically market, right, and then there's things that are not market, meaning, you know, they're standard, versus at times, you know, people try to sort of land grab, if you will, or grab too much protection through the use of their non compete and non solicitation agreements. 

Ryan Barnett 3:37 And that leads method. It's a great introduction. And and I think that leads me straight to my next question. If you think about legal agreements, there's typically been going to be, I try to think of them in points of negotiation. And if you think about a non compete that there's going to be a duration component, and there's likely going to be some regionality, or there's going to be some focus areas. Matt, can you help me understand kind of, you know, what might be, as you mentioned, market standard for some of the durations that you'd see?

Matt Lockhart 4:09 yeah. I think an important distinction here to sort of introduce into the conversation is, is whether a seller is selling out or selling into the business and and we've you, we use that term a lot, selling out is, is you're, you're selling the business. You're, you've got as short a transition as possible, and then you are on to a different chapter. All together. Selling is in, is you're going to be a part of the business moving forward, and potentially you are going to be a shareholder in in the business. And the reason that I bring that up is that in the context of selling out, you know you can see non compete, non solicit. Education agreements as short as one year, or you could see them as long as five years. Now, I think that that bell curve, or that baseline would have it in the three year time frame, but again, somewhere between, you know, one and five years, if you are selling into the business, and in particular, if you are becoming a shareholder, your shareholder agreement will also have a non compete and non solicitation clause. And oftentimes you will see that shareholder aspect be on the longer end five years is oftentimes very typical for that non compete, non solicitation as part of the shareholder agreement. 

Ryan Barnett 5:54 Great guidance. And if I think about scope here as well, it seems like a non compete if I was to go, if I'm running a managed service provider today, and I wanted to go open a karate studio, but probably be fine if I wanted to go in open something that is still in The tech world, let's say an AI automation practice. Do not compete. Typically get into the what you can or cannot compete in. Or is there definitions around that area? 

Matt Lockhart 6:33 Well, they certainly should, Brian and and again, going to some people trying to be too broad with non competes and non solicitations. You know, oftentimes you would see in those situations where, where they aren't specified. Areas of specificity can be the services offered. It can be the technology, you know, could be technology channel relationship related. It could be geographically based. And so there's a number of different areas in which it is important and applicable to to specify within the agreement you know. So you know, for example, say that, using your example of a managed service provider, well, it would be applicable to specify that you know, CSP related or cloud sales or procurement of hardware and and the such you know, would be applicable as an aspect of of the non compete, because those are things that are being done by that company today. Now, say a firm is interested in or an A seller is interested in staying in technology, and they've got some experience in an aspect of system integration. Say it's ERP integration services that are typically directed towards a different customer set, right a more of an enterprise or, you know, upper middle market customer set, and so the service line is different, the technology is different, and the customer set is different. Well, that's where specific specificity matters, because that would be non competitive in nature and and the non compete shouldn't with constrain a seller from being in the technology market. But it's different. 

Ryan Barnett 8:57 I think that's some of the great nuances that think you're tackling are fantastic here, the breadth and the depth of the non compete has to be agreed to. And I should note, by the way, we are not lawyers. We're not pretending to be lawyers. These are just terms that we're going to see throughout agreements. And it's a practical question that we get all the time. People are looking at, if I sell my company today and I still need to make an earning somehow. How am I going to be able to do that? And that somewhat gets to just one of the other questions I have, which is, are non competes just really enforceable? You know, there's some states, California, Texas, Minnesota, you know that that treat them differently than than others. So in general, are, you know, how enforceable does a non compete look, and does, what kind of recourses does a buyer have in the case that there, there could be a competitive offering going forward? Yeah. 

Matt Lockhart 10:00 Yeah, certainly. And this is where we'll, you know, sort of tread lightly to your point we aren't lawyers and and, and the enforceability that is written into the non compete and non solicitation clauses, you know, can be specific and drawn out as well. You know, certainly any party can, you know, bring a matter forward to the courts, they can, you know, there's injunctions that can be made, if there are, if there is a clear line where, you know, a party can identify harm, you know, then those the aspect of harm that is generated and can be, You know, clearly stipulated. You know, typically, those agreements will call out that those things should have penalties and or recourse, or or the like now, how and where. You know those are the matters that are important to to work with your lawyer on to make sure that there's, you know, again, adequate and fair coverage, but not too broad and enforceability and or penalties are understood, and, and, and, and as well specified as to what is right applicable for some level of enforcement or or payment and what aspects are not. 

Ryan Barnett 11:56 Yeah, that's it all. Great points and again, work, work with your lawyer on these specifically, but understand there's going to be constraints here, within any agreement that you look at and Matt part of this, you've you've talked to non compete and non solicitation in the same breath. And most time when we have this topic, they are very much hand in hand. What is the, what is the nuance there? What is the difference between a non compete in a non solicitation clause? 

Matt Lockhart 12:30 Yeah, sure. I typically, you know, the aspect of non competition is related to customers, right? And so, you know, real simply, non compete, don't compete against, you know, don't compete for customers, right? And, and there's other aspects to it, but that's, that's obviously the most important. And non solicitation is, don't come after employees, right? So, and, and both are extremely important. You know, in our tech enabled services space, people are like gold, right? They are people based businesses. Talent is is incredibly important. And so the ability for a buyer to protect themselves against a seller poaching people is absolutely critical. And then, you know, obviously everybody thinks about the the aspects of, of don't go after don't go after customers.

Ryan Barnett 13:31 yeah. So if I hear this non compete, kind of, don't compete with as a business as a whole, a non solicit, don't, you can't, literally solicit employees, can don't poach employees, don't poach customers. So there's, they're they're similar, but buyers are going to treat them a little bit differently. They're gonna have independent clauses in your agreements that go after that. 

Matt Lockhart 13:56 Yeah, and, you know, Ryan, I mean, honestly, we have seen this quite a bit where, say, maybe it wasn't the founder or the CEO of the business, but there are other shareholders in the business, and those shareholders had to execute their own non competes and non solicitation agreements as past shareholders of the business, but they are in their entire career is in the space, and they wanted to continue forward in the space. And we have seen a number of times where those shareholders went after their network and and so it is a real deal. And so, you know, that brings in another layer. When there's a shareholder group and and all aren't equal. And, you know, maybe the main shareholders, you know, fine and dandy, because they were moving on, but other shareholders weren't. And so, you know, it sort of needs to be thought of. Work in the context of of everyone who those non competes and non solicitations are are applicable for 

Ryan Barnett 15:08 Right, right? It's that's really a great point, and that part of this is these seem boilerplate. I mean, everyone we've seen has been seen has been fairly similar. We oftentimes get into the non disclosure agreements. We could even see an element of this, especially with private equity firms, who have many different subsidiaries that they're dealing with. Is there any advice that you can give to a seller where they're dealing with a complicated entity, like a private equity group that may have a non that might completely strike a non solicitation or on compete costs? 

Matt Lockhart 16:02 You know Ryan, we have seen that. And oftentimes you will see that earlier on in this, in the assessment of an opportunity, as you talked about, some NDAs have aspects of non compete, non solicitation, a included in in the non disclosure agreement. And rightly so, because you know you're not talking about a definitive agreement, but you are starting to share information, and a buyer may have their hands on the employee list and and, or the customer list and, and, obviously, the seller wants a level of protection to know that. You know, I'm interested in exploring the opportunity, but you can't use the information that I'm giving to you as a competitive advantage for the buyer, you know, and so you do see groups try to strike at times. And I think fair to again, go back to what is market, what is the appropriate use of the non compete and non solicitation agreements at the certain times throughout a potential transaction, versus the the appropriateness of them in sort of the final agreements that are in place, Ryan Barnett 17:33 right? Okay. Matt, recently, we've come across deals in which there's a consideration, a cast cash consideration for a non compete. Can you explain to to the audience why a consideration might be part of a an LOI or a deal structure for that non compete? 

Matt Lockhart 17:56 Well, there can be a couple of different reasons. One one may be that it is, it's, it's difficult to to clearly delineate, right, the specificity of a non compete or a non solicitation for, you know, who it could be. A you know, an example, could be in the world of artificial intelligence. Well, artificial intelligence is changing, right? It's changing on a daily, weekly, you know, basis, and so a buyer may not be able to specify appropriately the areas that are applicable within a non compete yet they they know that they want the applicable coverage, and so they may write a broader than market coverage Right, a broader than market, non compete and or non solicitation? Well, it's not, it's it's difficult for that seller, in that case, to accept a broad agreement. But for monetary consideration, they may do so much more often the monetary considerations are related to non competes and non solicitations, you know, within an employment agreement, and that may be applicable as part of this conversation as well, right where a seller is joining the New firm as an employee, maybe not as a shareholder, but just as an employee, and they've got to sign a more restrictive, non compete than than what was in the transaction documents. Well, in that case, if they're signing a more restrictive. Non compete applicable to ask for some level of monetary financial compensation related to that. 

Ryan Barnett 20:11 Yeah, now that helps. Matt. Is there any mistake that you see sellers make when reviewing clauses around non competes? 

Matt Lockhart 20:21 I think sometimes we see sellers who are like, ah, you know, I'll sign anything, right? Because I'm not going to be in the business anymore. And, you know, I'm retiring, or I'm I'm going and and starting that taekwondo karate studio or or the like, and so they they may sign too broad and too restrictive and or too long of a non compete because at that point in time they didn't have any interest in the space or in the business anymore. Well, that can change, right? And so I think that you know, sort of the guidance is, is just do again, do do, what is market work with your lawyer as to what is applicable, even if you don't feel as though there's going to be any need for it, because, simply, you don't know the opportunities that could come forward in that time frame of the non compete, non solicitation that you're signing. 

Ryan Barnett 21:32 Yeah, and I think founders get antsy, and so it's, it's sometimes they just want to get back to work. And oftentimes that's back to work in an area that they feel comfortable with, and to that Matt kind of, the last question I got for you here is, what advice can you give to someone who is on a two year non compete? 

Matt Lockhart 21:50 Follow the non compete. Don't break it. It can be, it can be a slippery slope, right? Where you say, Well, yeah, that was a past customer and, but this isn't really the same service and, and you can sort of talk yourself into or they're not really gonna care, or this guy likes me more than he likes them, or, yeah, Whatever it may be, you can talk yourself into justification. And the fact of the matter is, is there rarely is a justification that where you are crossing the line, so understand it, live with it, and don't get don't get too close to that line. 

Ryan Barnett 22:40 Yeah, I thought you're going to say, go play more golf. 

Matt Lockhart 22:44 that's sometimes, you know, but, and it is, we are coming up on June in Minnesota, Ryan, so, you know, go play more golf is in our sight lines, as opposed to three months ago. 

Ryan Barnett 22:59 I appreciate the being on this topic here today, it's it's something that we do get questions about these non competes, kind of take a look, make sure that you're going past the boilerplate. Understand what you're signing. If you're a seller, were to reduce the number of years that are on that if you're a buyer, you're going to want to increase the number of years they're going to be in every every contract you deal with. So it's going to be something in a DC tension. The enforceability is going to vary greatly. And things like considerations, a cash consideration, can probably help enforcement a bit, at the very least, just to keep someone away, to understand that there's a section of money that was dedicated in a enterprise value boards, consideration for non compete and so keep you're going to work through them. The goal is not to be punitive to any way to either buyers sellers. And it's a negotiation point, and one that needs to really be discussed. Matt, I'll turn over to you that's, again, great topic. Appreciate any closing thoughts, and I'll let you close it out. 

Matt Lockhart 24:10 Sounds good. Ryan, thank you. Great topic and important one. There is some nuance to it, for sure. Work with your lawyer. It's a plug that we've that we've made a number of times. A good, experienced mergers and acquisitions lawyer is is really important. They're going to help you understand what market is and what isn't. Be open about your situation and and the considerations for the future. Certainly a non compete, non solicitation should not be a deal breaker, right? If it is getting to the point where it is breaking a deal, then I think important to look step back and think about the deal itself and. Opportunity itself, because this one should not be a make it or break it. So great, great subject. We look forward to getting mike back here next week and a harken to him with that, we'll tie a ribbon on it. Hope you enjoyed it. Please come back next week and we'll look forward to seeing you there.