Selling Your Business Interest - The Non-Compete Clause or Covenant Not to Compete

When you an ongoing business the last thing you want is for the selling owner or equity partner to set up shop across the street. So most buyers will have the seller agree to restrict their business activities for a certain period of time and in a certain defined geographic area. That is what this case is about. Sutton vs. Iowa Trenchless, L.C., No. 10-2114[1-582] November 23, 2011, In The Court of Appeals Of Iowa.

Found to be tried as a law action the Iowa Court of Appeals reviewed the Guthrie County District Court decision to not enforce a noncompete clause having to do with the sale of a trenchless boring business interest for $200,000. The buyers were equity partners who were buying out a third equity partner as his request. The seller filed a declaratory judgment action seeking to nullify the effects of the non-compete and non-interference clauses a part of the sale terms.

“While Iowa Trenchless believes this is a matter of first impression in Iowa, what both parties and the district court failed to ascertain is that Iowa has long held covenants not to compete between business owners as ancillary to a purchase agreement are viewed with more indulgence than covenants not to compete between employers and employees. See Brecher v. Brown, 235 Iowa 627, 631, 17 N.W. 377, 379 (1945), overruled on other grounds by Ehlers v. Iowa Warehouse Co., 188 N.W.2d 368 (Iowa 1971).”

The court explained the limits of the Rasmussen decision saying whether the standard of review for business sales is more stringent than for covenants between employers and employees was not addressed.

1 While Rasmussen involved a covenant not to compete ancillary to a business purchase agreement, our court was not asked to address the standard of review for covenants between owners versus covenants between employers and employees. 463 N.W.2d 703, 704–05. It is not appropriate to use a case to establish a proposition that was not required to be decided in that case. State v. Iowa Dist. Ct., 492 N.W.2d 666, 667 (Iowa 1992). Thus, while the issue of the standard of review in cases involving covenants not to compete ancillary to a business purchase agreement has been addressed by Iowa courts, it was not addressed in Rasmussen. 

Explaining how far the Iowa courts will go in interpreting the language used in the covenant the Court stated:

“(“In the sale-related covenant not to compete cases we do not apply a ‘strict construction’ as appellee asserts, but do hold the contract, being in restraint of trade and personal liberty, should not be construed beyond its fair import.”).

So what are the points of interest for the Court in deciding whether to enforce a covenant? Well, the elements to consider are the same for both, but employer-employee non-competes get a strict construction look. On this point the Court stated:

Despite this added indulgence to uphold covenants not to compete that are a part of a business purchase agreement, the factors a court analyzes in determining whether a covenant not to compete is enforceable are the same. In Lamp v. American Prosthetics, Inc. 379 N.W.2d 909, 910 (Iowa 1986), the court applied the following three-pronged test in an employee-employer covenant not to compete: “(1) [i]s the restriction reasonably necessary for the protection of the employer’s business; (2) is it unreasonably restrictive to the employee’s rights; and (3) is it prejudicial to the public interest?””

The bottom line for the Court is basically one of reasonable terms that don’t interfere with the public’s right to receive goods and services while limiting the protection of what’s being sold and the value given for the sale.

“[T]he true test is whether the restraint is such only as to afford a fair protection to the interest of the party in favor of whom it is given, and not so large as to interfere with the interests of the public. And the restriction must be reasonable, not oppressive, or out of proportion to the benefits which the vendee may, in reason, expect to flow from the restrictive features of the contract.

What the district court found wrong with this covenant were several things. One the geographic area was 350 miles and the court didn’t like that large an area. Second the work being bid on was mostly public service or school district projects were limited bidding was being made; a fact that hurts the public because competitive bidding was, in the Court’s view, not taking place. Obviously, if that is true it hurts the public. The third limitation the District Court didn’t like was the 7-year time frame; which the Court found overly long.”

Iowa Trenchless came back with an argument that persuaded the Court of Appeals it’s version was more accurate. It argued the newness of the business, that the selling equity partners knowledge of the inner workings of the business and the amount being paid all indicate the terms of the restrictive covenant were reasonable. With this the Court agreed.

“Iowa Trenchless urges us to enforce the covenant under the less-stringent standard above. It asserts the 350-mile radius only covers the area that Iowa Trenchless actually performed services as seen in the map it provided to the district court. It also asserts the seven-year restriction is reasonable as the company was young when Sutton left, and the company needed to protect its goodwill and growing reputation. It also claims the covenant was needed to prevent Sutton from competing against it, particularly because Sutton was intimately familiar with the finances, customers, and inner working of the company. We agree.”

When it comes to business sale covenants the Court looks closely at the area where the business’ customer base is at the time of sale. Stick with that fact and the restriction should be enforceable. Perhaps such a map and supporting data should be an exhibit with the sale documents.

“Iowa courts have not considered the reasonableness of a covenant not to compete as part of a sale of a business for many years, except in Rasmussen cited above. However, historically, so long as the covenant was limited to the area where the business actually performed services, it was upheld even if the time restriction was unlimited. See Uptown Food Store, 255 Iowa at 475-477, 123 N.W.2d at 67-68 (holding agreement not to compete contained in lease of property for a grocery store was enforceable, where lessor agreed not to engage in the food retail business within the city during the term of the lease and any renewals); L. H. Henry & Sons v. Rhinesmith, 219 Iowa 1088, 1090, 260 N.W. 9, 10 (Iowa 1935) (holding as enforceable an agreement between buyer and seller of a newspaper where seller agreed not to compete with buyer for fifteen years in the town where newspaper was located); Haggin, 209 Iowa at 946-47, 229 N.W. at 260 (enforcing an agreement between partners who were splitting up their business and agreed not to compete with each other so long as the other partner was still in the business in the town and surrounding area); Swigert & Howard v. Tilden, 121 Iowa 650, 662, 97 N.W. 82, 85 (1903) (holding an agreement for the sale of the goodwill of a shirt retail business was enforceable, where restriction provided for no competition for an unlimited period of time within 100 miles of Des Moines and for ten years in the states of Iowa and Nebraska); Cole v. Edwards, 93 Iowa 477, 480, 61 N.W. 940, 941 (1895) (finding an agreement for the sale of a medical practice to partner was enforceable, which restricted the seller from practicing in the town and in the immediately surrounding county indefinitely).”

The Court further delineates their focus for determining reasonableness will be on what the facts were at the time the agreement is signed and that continued justification is not a burden the buyer shoulders.

“The district court found Iowa Trenchless presented no evidence as to why the covenant was still needed for the protection of its business for the remaining two years. The justification for the covenant is determined at the time the covenant was executed. Ehlers, 188 N.W.2d at 373 (stating an employer’s burden to show the reasonable necessity of the covenant is ascertained when the employee left company). It is not Iowa Trenchless’s burden to continually justify the covenant. So long as it was necessary and reasonable for the protection of the purchaser’s business at the time the covenant is executed, it is enforceable for the term of the contract. “

As for the District Court’s perceived harm to the public, the Court of Appeals was not impressed with the evidence. The decision does not catalogue competitors in this business so it’s difficult to understand the evidence and to draw conclusions; anyone interested in how many competitors are in this field would need to contact the attorneys involved.

“We also find the public interest was not harmed by this covenant. The covenant did not result in a monopoly or even in a reduction in the number of companies that do trenchless construction. It simply prevented a new company from entering the marketplace. It is hard to see how the public would be harmed by this restriction. See Swigert & Howard, 121 Iowa at 659–60, 97 N.W. at 85 (stating where there is the substitution of one business owner for another, the interest of the general public is infinitesimal).”

So is there greater scrutiny of B2B non-competes? Yes and here is the appellate court’s language leaving no question on this point. (Edmund J. Sease and Jeffrey D. Harty of McKee, Voorhess & Sease, P.L.C., Des Moines, for appellant. Matthew J. Hemphill of Bergkamp & Hemphill, P.C., Adel, for appellee.)

“We find the covenant valid and enforceable considering the greater scope of restraint that is permitted in owner-to-owner covenants not to compete.”

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Court’s Summary

No. 10-2114. [1-582] SUTTON v. IOWA TRENCHLESS, L.C.

Appeal from the Iowa District Court for Guthrie County, Gary C. Kimes, Judge. REVERSED AND REMANDED. Heard by Sackett, C.J., and Vaitheswaran and Tabor, JJ. Opinion by Sackett, C.J. (17 pages)

Iowa Trenchless, L.C. appeals the district court's decision granting declaratory relief from a covenant not to compete to Michael Sutton, a former owner of Iowa Trenchless. Iowa Trenchless contends the district court erred in applying the standards governing the reasonableness of an employer-employee covenant not to compete to this case, which involves a business owner's sale of his interest. Iowa Trenchless asks that we adopt a less stringent review and grant more deference to covenants not to compete between owners, which are ancillary to the sale of a business. It contends if the appropriate standard of review was applied in this case, the covenant not to compete would be found enforceable. In addition, Iowa Trenchless asserts the district court erred in denying its breach-of-contract counterclaim against Sutton. OPINION HOLDS: We find the standard applicable in determining the reasonableness of a covenant not to compete as part of the sale of a business is not a matter of first impression. Iowa courts have long held covenants not to compete between owners of a business are entitled to more indulgence and a greater scope of restraint than covenants between employers and employees. However, the same reasonableness test is applied in both situations. As a result of this more deferential standard, we find the district court erred in determining the terms of the covenant between Iowa Trenchless and Sutton unenforceable. We also find the district court's conclusion that Iowa Trenchless failed to prove Sutton breached the terms of the covenant was supported by substantial evidence. Thus, we remand this case to the district court for a hearing to determine the amount of attorney fees Iowa Trenchless is entitled to recover as a result of its successful claim that the terms of the covenant are enforceable, but Iowa Trenchless is not entitled to recover attorney fees incurred in attempting to support its breach-of-contract claim.