Restraint of Trade terms help to protect both the buyer and the seller when a business changes hands. Rolf Howard, Managing Partner at Owen Hodge Lawyers, explains how it works and outlines the requirements for both sides of the sale.
Buying a business is an exciting venture. However, when buying a business it is important to put certain restraints into place that will protect the viability of the business moving forward.
There is nothing worse than purchasing a new business, only to have the vendor turn around and start the same business within a time frame or geographic area that would pull their old clientele along with them. Such an action would render the new owner with a business that would be far less valuable than originally anticipated.
Basic Restraint of Trade requirements
To protect the interests of both the buyer and the seller, the courts have allowed for the contract of the sale of the business to include restraint of trade terms.
Ordinarily, a restraint on anyone’s right to do business or hold gainful employment, would be considered illegal. But under these circumstances, if a restraint of trade term meets the requirements of being both reasonable and necessary, courts will uphold them.
There are two factors that must be met for a restraint of trade agreement to be considered valid and enforceable:
- The terms must be reasonable; and
- The terms must not harm public interest
Of these two requirements, the reasonableness of the terms is always the most scrutinised. This is because the protections put into place by the terms of the restraint cannot be overly burdensome on either party.
Three factors will be taken into consideration when determining the reasonableness of a restraint of trade agreement:
- The type of restraint imposed: i.e. Is the restraint properly limited to only those actions that could reasonably harm the ability of the new business owner to thrive?
- The duration of the restraint: i.e. Is the restraint limited to a period that allows for the vendor to return to the business within a reasonable period?
- The geographic area of the restraint: i.e. Is the restraint limited to the immediate area and a limited portion of the surrounding area of the business?
If all three of these factors are considered to fall within reasonable parameters of restraint, then the restraint of trade clause will, most likely, be enforceable by either party.
Once a buyer or a vendor fully understands the basic requirements of a restraint of trade clause, they can then work together to make sure that the final terms of the clause are fair and reasonable to both parties by using a cascading clause.
A cascading clause will allow greater detail to be put into place regarding the type, time, and geographic area of the restraint.
For example, the following can be included in a cascading clause:
- The type of restraint can be initially quite significant but then reduced as time goes by. Hence the initial restraint may call for the vendor not to engage in all activities that are the same as the business being sold. But, after a period, the vendor may be allowed to re-engage in various parts of the same or similar business.
- The duration of the restraint may be for as much as a three (3) to five (5) year period, but it is possible to use language that allows for the restraint to be reduced after the first two or three years have passed. The terms may be reduced again after another year has passed. And then, at the end of the final year of the cascading clause, the restraint of trade is removed entirely, and the vendor may, once again, engage in the same or a similar business model.
- The geographic area of the restraint should be complementary to the actual geographic area of the business. For example, if the reach of the business is within New South Wales only, then the geographic restraint should mirror the same area. As such, if the business is local, a geographical restraint covering all of Australia would not be considered reasonable.
Types of restraining clauses
Finally, there are two main types of restraint clauses, these are:
- Non-compete clause: A non-compete clause prohibits the vendor from opening a competing business inside of the terms laid out in the restraint of trade agreement.
- Non-solicitation clause: A non-solicitation clause prohibits the vendor from taking the businesses clientele with them when they leave.
Both restraints can be included in your restraint of trade agreement and, for the sake of fully protecting your business purchase, it is highly recommended that as the buyer you insist on both being included.
Purchasing a new business is a thrilling and cumbersome event in the life of any person, even the most experienced of businesspeople. Therefore, regardless of how many times a buyer has been through the process or a vendor has sold a business, it is always advisable to work with those professionals who specialise in the transfer of businesses on a daily basis.
Want more? Get our newsletter delivered straight to your inbox! Follow Kochie’s Business Builders on Facebook, Twitter, Instagram, and LinkedIn.
Now read this: