Having been involved in a fair number of due diligence reviews over the course of my career, I can’t imagine there is a single due diligence checklist that doesn’t include an examination of key employment agreements. And anyone tasked with performing that assessment would certainly check to ensure those agreements include post-employment restrictions for those key employees. Having litigated employment disputes for over 20 years, however, I’ve come to the realization that going just a few steps further than what may be found on the typical diligence list can prevent a lot of headaches, distractions, and costs that so often occur post-transaction.

I’ve been involved in non-compete cases where acquiring companies relied on non-compete agreements that were poorly written, laughably overbroad, or just plain non-existent. But while the acquiror is buying the intellectual property, tangible property, and goodwill of its target, it is also buying its revenue streams, which are contingent on being able to maintain the target’s customer base. Failing to adequately assess the enforceability of restrictive covenants in key employment agreements may impact the acquiror’s ability to retain those employees. Furthermore, they will certainly affect the value of the forward-looking business of the company.

Resisting the Urge to Check the Box on Non-Competes

Some due diligence undertakings can undoubtedly seem tedious – reviewing bylaws, organizational charts, leases, and license agreements, for example. It would be easy for employment agreements to fall into this group of check-the-box tasks, particularly when it comes to reviewing them for restrictive covenants. After all, such provisions are customarily set off in their own section with the heading “Non-Compete” or something to that effect. It would be easy then to flip to the second or third page of the agreement, find that heading, scan for the typical time, territory, and scope components, and move on to the next item on the checklist. That would be a mistake.

Which Employees Really Cause Concern and Which Documents Govern

Even before the recent series of state laws redefining the bounds of enforceable restrictive covenants, a review of potentially applicable, state-specific restrictive covenant law would be worthwhile. Reviewers should also resist the temptation to assume that a choice of law provision does or does not apply. And, when it comes to assumptions, those engaged in the due diligence process should ask potential acquirors for an exhaustive list of any employees. This list should include key employees and their loyalists, from whom competition would be undesirable.

It would also be wise for reviewers to consider the full panoply of documents that might include restrictive covenants for key employees. I’ve seen plenty of employees’ hopes rise on the absence of a non-compete in their employment agreements, only to sink on the discovery of the very same restrictions in a stock grant agreement. Identifying a complete list of documents that could potentially contain restrictive covenants can provide a second chance at securing the desired protections.

The Non-Solicitation as Savior

The absence of a non-compete or the existence of a poorly drafted version should not necessarily signal disaster for the contemplated transaction or the success of the business going forward. Many employment agreements also contain non-solicitation provisions, which don’t always receive the same scrutiny as non-competes. However, they may still provide safeguard against the loss of important customers.

To determine whether a covenant not to solicit customers (or even potential customers) provides the protection an acquiror desires, reviewers should: (1) review the provision for enforceability; (2) work closely with acquiring entity to determine exactly which customers would have a material impact on the purchase price for the target company; (3) determine the financial impact the loss of those customers would have on the combined entity; and (4) inquire into the source and strength of the relationship with customer relationships in need of protection.

While restrictive covenants generally provide legal protection, it may ultimately be the nature of the relationship with the customers that determines whether departing employees are able to move that business. Learning which employees possess relationships with key customers is an important part of the due diligence process that may not always appear on the checklist.

And If All Else Fails, a Well Drafted Non-disclosure Provision May Be Your Friend

The third leg of the restrictive covenant stool is the non-disclosure provision. Even absent enforceable non-compete or non-solicitation provisions, non-disclosure restrictions – combined with the protections of state and federal trade secret protection laws – are powerful tools in preventing unwanted competition. But their sheer existence isn’t enough.

Reviewers should first check to see which categories of documents are purportedly covered by the non-disclosure provision. Typically, these provisions are so broadly written that they can appear all-encompassing. Courts are unlikely to dismiss misappropriation claims based upon the breadth of these restrictions. Overbroad provisions may, however, make it easier for judges to deny enforcement based upon the employer’s inability to adequately define the specific confidential information or trade secrets the departing employee is accused of misappropriating. A well-drafted non-disclosure provision may make up for any shortcomings in applicable non-compete and non-solicitation provisions.

Using Confidentiality to Probe Other Areas

While non-competes are generally required to be contained in employment agreements, amendments to those agreements, particularly when a transaction seems imminent, may raise unnecessary suspicions. If conducted far enough in advance of the transaction, due diligence may allow the acquiring company to step in and beef up confidential information protections. Confidentiality agreements, policies regarding the retention and use of confidential information, and trade secret protections can all be implemented, revised, or updated without roiling employees. And they may need to be if the new employer wants to be able to enforce them.

Perhaps in response to the growing number of trade secret cases being filed, the North Carolina Business Court has increasingly required employers to demonstrate the protections they have undertaken to protect their purported trade secrets. These protections can include password protection, limiting access to important information, marking documents confidential, and otherwise securing that information.

While there’s not much to be done to enhance protective measures at the litigation phase, there is time prior to the consummation of the proposed transaction. After all, many of these things are best practices and have benefit beyond being able to demonstrate to the court that the purported trade secrets were actually treated as such.

While due diligence, particularly the contract review portion, may seem banal, it does provide an opportunity to secure the continued employment, or at least not competition, from key employees. It may also allow the acquiring company to avoid costly non-compete litigation that so frequently follows a closing – which can be particularly distracting at a time when the company is trying to focus on integrating the two businesses, securing customer relationships, and transitioning to a merged entity.

March 2, 2022/by Business