Non-compete agreements have recently become a national topic of discussion, with policymakers signaling a revitalized effort to address systemic inequalities via a new federal regulatory regime. In July 2021 President Biden issued an Executive Order encouraging the FTC to exercise its rulemaking authority to diminish the unfair use of non-compete clauses that limit worker mobility. And earlier this year, the FTC issued a Notice of Proposed Rulemaking prohibiting most non-compete agreements on the grounds that such agreements are unfair methods of competition in violation of §5 of the Federal Trade Commission Act.

Exceptions to California’s Ban on Non-Competes

Historically, state law has governed the enforceability and the permissible scope of non-compete agreements. California has long spearheaded efforts to increase worker mobility and is among a coalition of states that already aggressively scrutinizes the enforceability of non-compete arrangements. Both current California law and the FTC’s proposed rule include an exception for permissible non-compete agreements when entered into in connection the sale of a business or its assets. The purpose of this article is to compare the California’s sale-of-business exception with the FTC’s proposed rule.

California Business and Professions code §16600 is a general prohibition on non-compete agreements that effectively voids “every contract by which anyone is restrained from engaging in a lawful pr ofession, trade, or business of any kind.” However, the statute includes a sale-of-business exception which allows any business owner who sells: (i) the goodwill of a business, (ii) all of their ownership in a business entity; or (iii) all or substantially all of the assets of a business together with the goodwill of that business, to contractually agree with the buyer to refrain from carrying on a competing business within a specified geographic area. In relation to goodwill, California courts have pointed out that the rationale of allowing a non-compete clause in connection with a sale of a business is to prevent the seller from depriving the buyer of the full value of its acquisition, including the “sold company’s ‘goodwill,’” which is defined as the “expectation of continued public patronage.” Cal. Bus & Prof. Code §14100; see also NewLife Sciences, LLC v. Weinstock, 197 Cal. App. 4th 676, 128 Cal. Rptr. 3d 538 (2011), and Alliant Ins. Services v. Gaddy, 72 Cal. Rptr. 3rd 259, 277 (2008). The California exception also requires that non-compete agreements be limited in geographical area and scope of activity. California courts have held that the purpose of the sale-of-business exception is to protect the buyer’s interest in preserving the goodwill of the acquired corporation, and as such the geographic scope of a noncompetition agreement must be limited to the area where the selling company carried on its business. Strategix, Ltd. v. Infocrossing West, Inc., 142 Cal. App. 4th 1068, 48 Cal. Rptr. 3d 614 (2006).

Comparison between the FTC Proposed Exception and the California Exception

The FTC’s proposed rule includes an sale-of-business exception for non-compete agreements entered into in connection with the sale of business by a seller who holds at least 25% ownership interests in the business and is also selling all of their ownership interests, or all or substantially all of the business’s assets. When compared against the current California exception to the general rule against non-competes, the FTC’s proposed exception would effectively narrow the exception – meaning that parties to a merger or acquisition would have less flexibility to enter into enforceable non-compete agreements. Firstly, the California exception applies to the sellers of a Company’s goodwill, and the FTC proposed rule does not make this distinction. More notably, the California rule does not include the 25% threshold, and as a result buyers often negotiate for non-compete obligations from a broader set of owner-sellers. If the FTC’s proposed rule becomes final it will supersede any state statute, regulation, order, or interpretation to the extent that such statute, regulation, order, or interpretation is inconsistent with the proposed rule. As a result, buyer parties in M&A transactions will have no practical way to restrict sellers who own less than 25% of the selling entity from competing with the business being sold.

On the other hand, the California exception requires non-compete agreements to be limited in geographical area and scope of activity, the FTC’s proposed exception does not include any such limitations, meaning an enforceable non-compete agreement could theoretically cover a larger geographical area and wider range of activities under the FTC’s proposed rule. However, states are free to supplement the FTC rules with a broader set of protections at the state level, and as a result the California limits on geographical area and scope of activity would apply to any non-compete agreement that fits within the FTC’s exception.

On balance, the FTC proposed rule is more narrow than the California exception, and would significantly hamper the ability to enter into non-compete agreements in connection with the sale of a business. The 25% ownership threshold of the proposed rule represents a major change to California’s sale-of-business exception and has the potential to disincentivize buyer parties in M&A transactions. It is common for employee-owners of selling entities to own less than 25% of the selling company while simultaneously being the face behind the brand. This is especially true in venture backed companies, where charismatic and well connected founders often own less than 25% of their company after successive rounds of fundraising. Buyers may be less willing to acquire target companies if they cannot enforce non-compete agreements on sellers who own less than 25% of the selling entity. It is reasonable to expect that Buyers will ask for a lower purchase price and insist on installment payments when making an acquisition to compensate their inability to enter a non-compete agreement with sellers who own less than 25% in the selling entity. In other words, the FTC’s narrow proposed exception with a 25% ownership threshold may end up reducing Seller’s bargaining power and ability to secure a high sale price with a large cash payout at closing.

From an acquirer’s perspective, the FTC’s proposed rule is potentially worrisome because, as drafted, the rule is retroactive and would invalidate prior non-compete agreements that do not fit within its narrow exception. As such, non-competition agreements between an acquirer and the former employee-owners of an acquired company would be invalidated – despite the fact that the transaction has already closed with the non-competition covenants factored into the purchase price, and the former employee-owners of the acquired company would be free to directly compete against the acquirer.

Next Steps: Predictions and Practical Guidance

With that said, parties to M&A transactions should not hit the panic button just yet. As mentioned above, the FTC’s proposed rule is still in draft form and does not yet carry the weight of law. Many commentators, including former FTC Commissioner Christine Wilson, predict that the proposed rule will be subject to successful legal challenges if finalized. Additionally, the FTC is considering alternatives the categorical ban on non-competes, including a rebuttable presumption of unlawfulness and a categorical differentiation that applies different standards and exemptions based on a combination of factors.

While most commentators predict that the FTC will eventually pass new regulations on non-competes, no one can guess exactly what the new rules will be or when they will be final. One thing businesses can do now is revisit their existing non-solicitation and non-disclosure agreements. These agreements will not be impacted by the new rule if they are carefully drafted and reasonably tailored to protect legitimate business interests. Further, companies are encouraged to identity their trade secrets and ensure that proper policies and procedures are in place to limit access and protect against theft. Trade secret protection was explicitly cited by the FTC as a factor mitigating the harm of abrogating non-competition agreements, and all are advised to consult their legal counsel to ensure they are adequately protected.