When a business is sold, the buyer is often paying for more than its physical assets. Customer relationships, reputation and goodwill can make up a significant part of what is being acquired, making their protection after settlement an important consideration.
To help protect that value, a sale of business agreement will often include restraint of trade clauses restricting the seller from undertaking certain activities after the sale is completed.
For buyers, these terms can help safeguard what they have purchased and reduce the risk of the seller competing with the business. For sellers, it is important to understand exactly what activities are restricted, for how long and across what geographical area before agreeing to the terms.
The scope of the wording can determine how effective it is, as a restraint that is too broad may be difficult to enforce and one that is too narrow or unclear may not provide the buyer with the protection they expected.
The purpose of a restraint in a business sale
A restraint of trade clause is usually imposed on the seller and sets limits on what they can do after the business changes hands.
Depending on the transaction, this may include preventing the seller from establishing or working in a competing business, soliciting or dealing with former customers, approaching employees or encouraging them to leave the business.
These restrictions are intended to protect the commercial value being transferred as part of the sale and prevent the seller from undermining the business after settlement.
These clauses are considered in a different commercial context to restraints in employment contracts, as the buyer has generally paid for the commercial value the provision is intended to preserve.
The scope of a restraint
When considering whether a clause is enforceable, Courts will look at whether its scope is reasonable and proportionate to the business and the interest being protected. This may involve considering matters such as:
- The activities covered by the restriction;
- The geographical area in which it applies;
- The length of the restraint period;
- The nature and location of the business;
- The goodwill and customer relationships being acquired; and
- The circumstances in which the agreement was negotiated.
These factors help Courts determine the level of protection that can reasonably be justified in the circumstances.
A restraint that is broader than the buyer’s legitimate interests require may be open to challenge.
Restraints of trade in New South Wales
In New South Wales, these provisions are governed by the Restraints of Trade Act 1976 (NSW).
Section 4 provides that a restraint of trade is valid to the extent that it is not against public policy. This means that if part of the clause is too broad, it will not necessarily invalidate the restraint as a whole.
A Court may instead enforce only the part it considers reasonable.
For someone buying or selling a business in NSW, careful drafting of the restraint is particularly important. The restriction agreed to in the sale contract may not ultimately be enforced exactly as written if a dispute arises.
For buyers, this highlights the importance of carefully considering the scope of the restraint at the time of sale. Sellers should also be aware that even where the terms are drafted broadly, a Court may still enforce them on a narrower basis.
The limits of an enforceable restraint
The decision in DXC Eclipse Pty Ltd v Wildsmith [2023] NSWCA 98 provides a useful example of how a clause can be tested by the Courts.
The case followed the sale of a software business and involved a restraint preventing the former owner from engaging in competing activities for up to seven years.
The purchaser later sought to enforce the clause after the former owner became involved in another software business. However, the NSW Court of Appeal found that the restraint had not been shown to be reasonably necessary to protect the value of the original transaction. The Court also found that the new venture was not sufficiently in competition with the business that had been sold.
As a result, the purchaser was unsuccessful in enforcing the restriction against the former owner, who was able to continue his involvement in the new business.
The case shows that even where these terms are negotiated as part of the transaction, its scope must still be closely connected to the interests the buyer is seeking to protect. A broad restraint will not automatically be enforceable simply because both parties agreed to it.
Key considerations for buyers
Buyers should consider exactly who needs to be bound by the terms. If the business is operated through a company, restraining the company alone may not be enough where important customer relationships or commercial connections are closely tied to particular individuals.
It is also important to consider how the seller will be involved after settlement. If they are staying with the business for a period, the restraint needs to work alongside that arrangement, including when the restrictions begin and how they apply once the seller leaves.
For buyers, the key is identifying the areas of the business most exposed to risk and ensuring the clause is drafted around them, rather than relying on broad wording.
Key considerations for sellers
Sellers should carefully consider every aspect of the proposed terms before agreeing to them, particularly how it may affect their ability to work or operate a business in the future.
Depending on its terms, a restraint can limit where a seller works, the type of business they can be involved with and who they may deal with after the sale. A restraint may also extend to other forms of involvement with a competitor, including working for, advising or otherwise assisting that business.
This is particularly important for sellers who may want to remain in the same industry, take up another role or establish a new business several years after the sale. Restrictions agreed to at settlement can continue to affect those options well into the future.
The duration, geographical reach and activities covered by the restraint should therefore form an important part of the sale negotiations. Sellers should be clear on exactly what they are giving up before the agreement is signed.
Consequences of breaching a restraint
A breach may occur where a seller acts contrary to the restrictions in the sale agreement.
If a buyer believes a restraint has been breached, they may seek urgent legal action to prevent the conduct from continuing. This can include applying for an injunction, which may temporarily limit the seller’s activities while the dispute is being determined.
The Court will consider both the terms of the agreement and whether the restriction being enforced is reasonable and necessary to protect the buyer’s legitimate interests.
Where a breach has caused financial loss, the buyer may also seek damages. This could become relevant where customers, contracts or other business opportunities have been lost as a result of the seller’s conduct.
For both parties, a dispute can also bring significant legal costs, particularly where urgent Court proceedings are required. This makes it important for buyers and sellers to understand the restraint before the sale is completed and to seek advice quickly if a potential breach arises.
Getting the terms right before the sale
These provisions should be considered carefully before a sale agreement is signed. Clear, well-drafted terms can help protect both parties and reduce the risk of costly disputes later.
Aubrey Brown Lawyers advises buyers and sellers on the sale and purchase of businesses, including the negotiation and drafting of restraint of trade provisions.
