Mintz On Air: Practical Policies — A Private Equity Non-Compete Primer

Member Jen Rubin is joined by Associate Tom Pagliarini to discuss the strategic use of restrictive covenants in private equity transactions. This episode is part of a series of conversations designed to help employers navigate workplace changes and understand general legal considerations.

Together, Jen and Tom explore:

1. Understanding restrictive covenants and their common forms
2. Private equity and the role of restrictive covenants
3. Deal structuring and aligning buyer and seller interests
4. Legal enforcement and jurisdictional challenges
5. Practical takeaways for buyers and sellers

Listen for insights on how to approach restrictive covenants thoughtfully and strategically in the context of private equity deals.

Transcript: A Private Equity Non-Compete Primer

Jen Rubin (JR): Welcome to Mintz On Air, the practical policies podcast. Today's topic: A Private Equity Non-Compete Primer. I'm Jen Rubin, a Member of the Mintz Employment Group with the San Diego based bicoastal Employment Practice representing management, executives, and corporate boards. Thank you for joining our Mintz On Air podcast. If you have not tuned in to our previous podcasts and would like to access our content, please visit us at the Insights page at mintz.com or on Spotify.

Today, I'm really happy to be joined by my Boston-based employment colleague, Tom Pagliarini, who began his career as a litigation lawyer, but then turned his attention to employment law. He now uses that background in his practice, counseling on employment aspects of private equity transactions. Welcome, Tom, and thanks for joining Mintz On Air. So today our topic is about non-competes in private equity transactions.

Tom Pagliarini (TP): Thanks for having me.

Understanding Restrictive Covenants and Their Common Forms

JR: Before diving in, I think it's always helpful to set the table and briefly discuss what we mean by these things. Tom, before we even dive in and start pulling these things apart, can you explain to us what the term ‘restrictive covenants’ means and what comes within that umbrella?

TP: Sure. So restrictive covenants can really mean any sort of agreement whereby a person, whether that be an individual or an institution, is agreeing to certain limitations on what they could otherwise do in the conduct of their business. But there are certain common ones that have developed some sort of key core restrictive covenants that fall under that umbrella. One of the first is confidentiality and intellectual property protections.

We call those the “must-haves,” and that's protecting all the secret sauce and all the good things that are internal to a company that the company doesn't want the public to know about. It has great business value. That's a must-have in any sort of restrictive covenant situation. The other one that we will talk about further here is non-competes. This is sometimes the most contentious of the restrictive covenants. It places a limitation on sellers or individuals from entering into competitive businesses with the other party. It's blocking them from engaging in the industry in which the other party operates. Then there are non-solicitation provisions, and that can be non-solicitation of customers or business relationships, or non-solicitation or no-hires of employees or service providers.

Sometimes the non-solicitation language is a little bit of a misnomer because non-solicitation can not only prevent the actual soliciting — like going out and knocking on doors and contacting either customers or employees — but it can really prevent the restricted party from actually doing any business with the customer or going out and hiring or engaging the service provider. To some extent, it can operate more or less as a no-contact or no-work-for type of provision.

One of the last ones, and it's a little bit amorphous, is non-disparagement provisions. This prevents negative statements about the other party. What that means to different individuals is sometimes tough to tell. It's a little bit more of an amorphous concept, and it's a little bit “know-it-when-you-see-it” type of thing. But generally speaking, it prevents saying bad things about the other side.

JR: Okay, so it sounds like a lot of these restrictions are things that are generally seen in writing, they're parts of agreements. We're going to dive into that in a few minutes, but it's certainly something that can come up in the context of a sale, acquisition, or transaction. But let's specifically talk about private equity. Before we start talking about the non-compete portion, explain to us what you mean by when you use the term “private equity.” What is it and why do we care about it?

TP: Sure. In one sense, it can be very literal. It's an interest in a private entity, but then there are layers of complexity in describing what we mean by that literal definition. Private equity sometimes refers to the industry that's built out around the process of investing in and selling interests in private, non-publicly traded, non-listed companies.

It's the industry that's developed out of that whereby a private equity company, a firm whose business is buying and selling these interests, will take funds from say institutional investors, high-net-worth individuals, and pool those funds together. Then the private equity company will invest in other private companies with the goal of later on selling the interests in those private entities and returning the profits that are achieved from holding on, selling, and growing those private companies and returning those gains to the investors that have given them money to pool together to make those investments. It's a whole cottage industry that's developed out of owning and selling these interests in these private companies.

Private Equity and the Role of Restrictive Covenants

JR: Interesting to me, it's basically the business of making investments and hopefully making money on them. The essence of capitalism. When we talk about private equity, what's interesting is that it has now become part of the public markets as well. Another thing to note is that some public companies are now heavily engaged in private equity.

TP: There's been increased prominence of private equity in the American workforce. Taking a look at statistics, the industry was in its nascent stages in the 70s, 80s, and 90s. Then from 2000 and beyond, some statistics indicate that there's been about a 400% increase in the number of private equity-backed companies and that roughly 20% of US businesses have some type of private equity backing. It's really permeating throughout the American workforce and becoming much more prominent in more and more people's day-to-day lives.

JR: So big numbers here in terms of impact on employees. Let's use that as our segue. How do restrictive covenants, as you have described them, fit into these private equity transactions?

TP: Sure. They are definitely a key component of the overall private equity industry because they're an essential tool that can be utilized by the private equity company and their individual portfolio companies to protect the investment and the value that they've created in that specific company. On the flip side of that, they're important because sellers might have the opposite interest. They are potentially acutely aware of restrictions that are being placed on their freedom to otherwise engage in activities that they'd want to engage in. So, taking a step back, there are special considerations from the buyer side of things — that is, the private equity company that's coming in and buying a company.

There are many different angles that can be played off of the broader concept of restrictive covenants. As the buyer, you might be looking to not only lock up the “sellers of the business,” — the people that actually own it — but you might also be looking at other key personnel that you'd be wanting to ensure are bound by restrictive covenants. There's a lot of strategy that sometimes has to be developed there, thinking about the different ways in which you can try to place restrictive covenants into different instruments. There are various ways to do that, and sometimes people take the approach of placing a restrictive covenant wherever you can get one.

Some of the key areas where restrictive covenants might come up would be deal documents — the actual purchase agreements and ancillary agreements for buying the company, if you will. We call that the deal restrictive covenant.

Then there's also areas to place restrictive covenants in any incentive equity or other types of long-term incentive plans that might be given to certain key personnel. In addition, even beyond the equity component, there might be opportunities where you're looking at, what does the person have in place for their existing employment agreements? Or do we need to go forward with employment agreements in which we might place restrictive covenants? It can pop up in a variety of areas.

Deal Structuring: Aligning Buyer and Seller Interests

JR: We often think of the seller as a single individual who may have put their heart and soul into developing the business that's sold. But in fact, the terms you use, Tom, are key personnel and team. It seems to me that there needs to be a focus on who the key personnel are — those who have built the value of the business and also can help run the business going forward for the buyer. Due diligence becomes an important aspect of these deals and understanding these things. Is that right?

TP: Absolutely. There's the business aspect of doing due diligence — really what is the state of play at the company from a business level? What are people's interests? Really understanding how the business got to where it is, who owns it, and who the key players are. Sometimes that's the actual legal documents, sometimes that's the personalities that might be in play. But really understanding where that is, looking at what's in place already, and certainly having an understanding of what agreements or other restrictions might be in place currently.

But then you're exactly right, not all sellers are the same. They could be the founder, they could be other management out there, they could be other private equity companies, or there could be institutional investors that are technically part of that seller group. I'd say, to some extent, all the sellers want a purchase price as high as possible, but their interests might not always be aligned regarding what that looks like in connection with that transaction.

The institutional investor might be looking to sell their interest and then potentially invest in a similar company right away. A founder might have, as you put it, put their heart and soul into the company, and they might have an interest, along with other management, in continuing to work for the entity post-closing. There might be some rollover equity in play, or there could be instances where the person has taken the opportunity to sell their interest, cash out, and has no interest in being a part of it. All those things are certainly important on both sides: the buyer understanding all the personalities that are in play, and the sellers looking internally — and to their left and right — to see who else is on the seller side of the transaction and what their interests are within the whole scheme.

Legal Enforcement and Jurisdictional Challenges

JR: It's a very interesting conundrum because you have the buyers wanting the protection for the asset that they're buying, and then the sellers who, of course, want to maximize the compensation or consideration for that baby that they brought in, but also want to preserve some flexibility for themselves for the future.

It’s interesting to me that these things are directly opposed, and this is where I think lawyers, of course, can come in and add value to help in this context. Turning toward that, because I mentioned lawyers, let's talk about the legal and practical limits. Let's start with goals, Tom. How do you achieve these goals in a way that fits within the legal paradigm?

TP: That’s exactly right, having an understanding of what people's goals are is really important. Having worked on both sides of transactions, representing both buyers and sellers, it’s crucial to have honest conversations about what they see, what they looking to achieve on business terms, and also when we get into the nitty gritty of the documents. Highlighting what is important — what are must-haves, need-to-haves, and what are nice-to-haves — is always an important conversation to have with individuals.

When you're talking about the aims of restrictive covenants, I'll kind of approach this one — to some extent —from the buy-side perspective. Restrictive covenants can serve many different purposes, but two broad-based ways to think about them are: first, inherently having them in place can have a deterrent effect on someone engaging in certain number of prohibitions. It keeps honest people honest, but it has that little bit of bite to it. And there's an important interest to that. There's some measure of giving pause to someone before they engage in certain conduct that might violate a restrictive covenant.

The other related point, but sometimes it's a little different, is not just deterrence, but ensuring that the agreement, the restrictions in play, not only act to prevent someone from entering a situation but also address the flip side: if we actually needed to enforce this thing. Say someone stares the face of a covenant down and says, “Well, you know what? I don't think I'm in breach. I'm going to go headlong in and go out and do something.” The question becomes: what am I going to be able to enforce in a court? That's a conversation.

To some extent, it's like trying to read a crystal ball because it's really tough. Courts can always do different things when faced with different circumstances. It's highly fact-specific. Having a sense of where the market is going and keeping up to date on different trends is very helpful in being able to advise on the likelihood of enforceability in certain instances.

JR: I imagine that determination and analysis is somewhat jurisdiction-specific.

TP: It is. It's highly jurisdiction-specific. While deal documents — like the actual purchase agreement — might, to some extent, default to Delaware just because of the robust corporate laws there, the many different ways that restrictive covenants can come into play, where you've got increasingly dispersed workforces, investors, and management all throughout the country, where people sit, quite literally in where they're located, where they're working, can directly impact the nature of the covenants that are at play. You're increasingly seeing different states take different approaches to impose certain requirements or outright try to prohibit certain types of restrictive covenants. So not only is it important to look at national trends, but being highly aware of the sometimes really intricate and detailed statutes that can pop up in various jurisdictions is equally important.

Practical Takeaways for Buyers and Sellers

JR: This is a great point. Of course, I'm sitting here in California, and I'm a bicoastal lawyer. California is, of course, the most famous — or some would say infamous — for having statutes that really support employee mobility, i.e. outlawing non-competes. However, there is a very significant exception for an individual who's selling the goodwill — a significant part of the goodwill — of a business, and restrictions in that context may well be enforceable even in California.

However, as you point out, simply picking a choice of law, such as Delaware, may or may not be a wise move in certain circumstances. It’s important to do a full analysis of the places where these executives are sitting, for example, and where they're performing services, and to make sure that all of these very specific state laws are considered, as they bear on this analysis. So it’s very important to be familiar with those laws and understand how they would apply, even if you're using a choice of law, because again, in California, you may run into some trouble if you don't do that properly.

So, practical takeaways, Tom — you know, for buyers. What would you say to a buyer who's looking to purchase a business, maybe operate it and, fingers crossed, sell it for a profit in the future? What should those buyers think about when they're entering into these transactions with respect to restrictive covenants?

TP: I definitely would say you should utilize restrictive covenants. I think it is almost an essential way to secure your investment. But some of the things that buyers should be thinking about are the approaches that they're going to take to utilize restrictive covenants. Some people might take a look and say, “What's the maximum I can get away with? What's the maximum that can be enforced?” That is one way to look at things.

Another approach to that principle is to say, “What's the minimum that I need to protect the business that I am either buying or selling?” So, two different aims. I think you can tailor what it is that you need depending on the specific circumstances, goals, and interests that you have. So those are some things that buyers can consider depending on the perspectives that they're coming from.

And then on sellers, you hinted at it earlier, I think on an individual level, whether that be the individual person or an individual entity, it’s important to have a good understanding of what the seller wants to do post-closing and to really focus on what the person might need to do. What flexibility they might need to have to ensure that they're able to give an honest restrictive covenant to the buyer, but still have the flexibility to carry on with whatever it is they might have contemplated in a post-closing situation. Like it or not, they'll have to live with those covenants, so it's good to have an understanding of what their plans are and how that will align with the restrictions that they've signed onto.

JR: I think the common thread here in the advice to buyers and to sellers is actually giving these things thought, which may sound obvious to many of us who work in this world, but sometimes these deals move really fast, and it's difficult to make sure that the thought has gone into, are we going for the maximum approach or the minimum approach? And then from the seller's perspective: what do you want to do, and have you really thought about what this means for your future in this world? Giving these issues consideration, to the extent possible, even when things are moving really fast is a practical takeaway today.

Thank you, Tom. Once again, I'm Jen Rubin, and those of you who have tuned into our Practical Policies podcast previously know that you can find us on Spotify. But for those of you interested in following our content, visit us at mintz.com. Thanks again.

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