When it comes to providing an SBA 7(a) loan to finance a “change of ownership”, SOP 50 10 6 states (in multiple sections), that the “purchase price of the business” includes all assets being acquired such as real estate, machinery and equipment, and intangible assets. Among the most often overlooked and misunderstood intangible asset is an “agreement not to compete”.

In a change of ownership transaction, an “agreement not to compete” (otherwise commonly referred to as a “non-compete”) is typically negotiated as part of the consideration for the purchase price pursuant to which the seller agrees not to have any involvement in a business similar to the type of business being sold following the closing of the sale. Non-compete agreements also often include prohibitions against the seller using the confidential or proprietary information, such as processes, customer lists, and other trade secrets, of the business being sold. While such non-compete agreements are intended for the benefit of the buyer, the terms of the non-compete are also important for SBA lenders to understand, and take into consideration, during the loan underwriting analysis.

Generally, there are three (3) common factors in a non-compete agreement:

  1. Scope. The types of industries, business activities, interests, involvement, roles and investments that the seller is prohibited from engaging, or participating, in during the non-compete period;
  2. Duration. The period of time during which the seller is prohibited from engaging in a competing business; and
  3. Protected Area. Geographic area within which the seller is prohibited from engaging in a competing business during the non-compete period.

Although the factors described above may seem relatively straight-forward, buyers and SBA lenders should take the steps necessary to understand how the Courts in the applicable jurisdiction(s) would enforce the non-compete agreement, should the seller improperly engage in a competing business. Some states have specific laws that set forth the specific requirements, and limitations, for non-competes and the courts must strictly enforce those laws. Other states follow “common law” whereby non-competes are interpreted, and enforced, based on prior court rulings. Generally speaking, “common law” non-compete rulings are based upon a court’s determination of what terms (scope, duration and protected area) were reasonably necessary to protect the interests of the buyer. A considerable concern arises due to the fact that a court’s determination of what is “reasonable” is often specific to the facts and circumstances of each case.   In addition, many jurisdictions treat buyer/seller non-competes differently than employer/employee non-competes.

The following are some additional best practices for SBA lenders:

  1. Confirm whether the applicable jurisdiction requires a stand-alone non-compete agreement, or whether a non-compete provision within a Purchase Agreement is acceptable;
  2. Ensure that the correct and appropriate individuals and entities are parties to the non-compete; and
  3. Understand that a non-compete agreement/provision is different than a non-solicitation agreement/provision which prohibits a seller from soliciting the business’s customers, clients or employees.

At the end of the day, the real-world value of a non-compete is the protection of the buyer’s business from direct competition by the seller. Depending on the type of business, direct competition from a seller could severely harm the success of a buyer’s business. Further, in certain circumstances, it is possible that a lender’s SBA guaranty could be in jeopardy if a borrower’s business were to fail due to direct, and avoidable, competition from the seller. Accordingly, it is prudent for SBA lenders to fully review and understand the non-compete agreements in change of ownership transactions.