Restrictive Covenants in Private Equity Transactions

Restrictive covenants are unquestionably a significant deal consideration in M&A transactions. In the private equity context, a buyer is focused on restrictive covenants to protect its investment by binding the sellers and other recipients of material deal proceeds to obligations and restrictions for a certain period of time following the transaction. Restrictive covenants serve several purposes and are highly beneficial for a buyer; accordingly, absent any legal limitations and assuming sufficient consideration, a buyer is incentivized to impose restrictive covenants on as many selling parties as possible. However, and not surprisingly, sellers heavily negotiate their post-transaction restrictive covenant obligations to keep their business options as open as possible on a go-forward basis. The conflicting interests of buyers and sellers when it comes to restrictive covenants result in carefully negotiated covenants spread out over multiple transaction documents and employment agreements. This article discusses the common restrictive covenants used in private equity transactions, the importance of such covenants in the key transaction documents, and related enforcement considerations.

I. Summary of Restrictive Covenants in Private Equity Deals

The most common restrictive covenants that a private equity buyer will want to include in any transaction are (i) confidentiality, (ii) non-competition, (iii) non-solicitation/non-interference with customers/business relationships and partners, (iv) non-solicitation/no-hire of employees/service providers, and (v) non-disparagement. While these are the most common, and key types of restrictions, there may be other restrictions that a private equity buyer will want to impose depending on the industry and nature of the deal, so it is recommended to consult with counsel to determine the scope and enforceability of any additional covenants.

A. Confidentiality

Confidentiality covenants are the most common type of restrictive covenant in a private equity transaction and are not typically controversial. These covenants provide that, subject to a few narrow exceptions, a party receiving confidential information will treat and hold such information in strict confidence and will not use or disclose any such confidential information for any purpose other than as expressly set forth in the applicable agreement. Further, a standard confidentiality covenant will include an affirmative covenant that such receiving party will take appropriate steps to safeguard confidential information to protect it against disclosure, misuse, loss, or theft. Confidential information usually includes, among other things, business information, contractual agreements with suppliers, customers or other business relations, trade secrets, inventions or innovations, and other intellectual property rights.

Confidentiality covenants often survive indefinitely. However, in certain transactions, the parties may negotiate a fixed survival period (i.e., the restricted period), between five to seven years following the closing of a transaction. In certain transactions with a fixed restricted period for confidentiality covenants, the parties may separately agree to a longer or indefinite survival period with respect to limited categories of confidential information (i.e., trade secrets) if such confidential information is particularly sensitive.

B. Non-Competition

Non-competition covenants are typically the most controversial restrictive covenant negotiated in a private equity transaction. Non-competition provisions provide that, subject to narrow exceptions and for a certain period of time following the transaction, the sellers and other recipients of material deal proceeds shall refrain from engaging in certain specified activities in a specified territory, or sometimes more broadly any activity competitive to the target company, whether directly or indirectly and whether as a shareholder, employee, investor, consultant, advisor, or otherwise. Private equity sponsors who are sellers typically do not agree to non-competition covenants in connection with the sale of portfolio companies. However, there are instances where the incoming private equity buyer may require that a private equity sponsor seller agree to a “no-buy list” which provides that such seller will refrain from thereafter acquiring a specific list of companies (or companies within a certain industry) which the private equity buyer has identified as potentially interfering with such buyer’s strategy and/or operations of the target company post-transaction. The extent to which a private equity buyer may insist on such no-buy list depends on the value proposition either being marketed by the private equity seller or identified by the buyer as inorganic growth opportunities, where a number of add-on acquisitions are considered essential for post-transaction growth of the target company. 

The survival period for non-competition covenants is often three to five years following the closing of the transaction, but, subject to applicable law, a private equity buyer may seek to restrict sellers and other recipients of material deal proceeds for a longer period of time if such seller or recipient received an outsized portion of deal proceeds or the industry is particularly sensitive to competition.

C. Non-Solicitation/Non-Interference with Customers/Business Relationships

Non-solicitation and non-interference covenants provide that, for a certain period of time following the transaction and subject to narrow exceptions, the sellers and other recipients of material deal proceeds shall refrain from (i) interfering with the relationship of the target company and/or the private equity buyer and its employees or independent contractors, and (ii) engaging in conduct designed to divert or interfere with the target company’s relationships with any of its customers, clients, or other business relationships.

The survival period for non-solicitation and non-interference covenants is often three to five years following the closing of the transaction, but, again, subject to applicable law, the private equity buyer may seek a longer survival period depending on industry standards, or the relative bargaining power of the parties.

D. Non-Solicitation/No-Hire of Employees and Other Service Providers

Non-solicitation and no-hire covenants provide that, for a certain period of time following the transaction, the sellers and other recipients of material deal proceeds shall refrain from (i) hiring or engaging, or soliciting for hiring or engagement, any individual that served as an employee or independent contractor of the target company at any time during a reasonable period of time prior to the closing of the transaction, and (ii) soliciting or attempting to persuade any employee or independent contractor of the target company to terminate his or her relationship with the target company. Non-solicitation and no-hire covenants often include carve-outs for general solicitations that are not targeted at such employees and for employees who have not been employed by the target company for a reasonably long period of time such that such employee’s hiring by a seller or an affiliate thereof would not be detrimental to the target company; provided that, a private equity buyer may require that the sellers agree to a strict no-hire of a small list of senior executives where the foregoing carve-out would not apply.

The survival period for such non-solicitation and no-hire covenants is often three to five years following the closing of the transaction, but a longer or shorter survival period may be appropriate in certain circumstances.

E. Non-Disparagement

Non-disparagement covenants typically provide that the parties shall not make any defamatory, derogatory, or disparaging statements intended to harm the reputation or business of the other party. Non-disparagement covenants commonly include exceptions to permit truthful testimony in a court or government proceeding or investigation. Non-disparagement covenants are often not controversial conceptually, but can be challenging to negotiate, including whether such covenants should be mutual or unilateral in favor of the buyer and target company, post-transaction. Generally, potential disparaging comments are more harmful to the private equity buyer than they are to sellers because the buyer is attempting to operate the target company whereas the sellers have exited the business. Given this disparity, a private equity buyer may insist that non-disparagement covenants be unilateral to avoid being subject to different obligations across platforms. However, sellers often resist unilateral non-disparagement covenants and, accordingly, such covenants may become a negotiation point for the private equity buyer to consider in the context of the broader transaction.

Non-disparagement covenants typically survive indefinitely, however, as above, the parties may seek to negotiate a fixed survival period of three to five years depending on the industry conditions, relationship with the sellers, or relative bargaining power.

II. Importance of Restrictive Covenants for Private Equity Buyers

Restrictive covenants in private equity transactions serve numerous important purposes for a private equity buyer. First and foremost, the private equity buyer wants to protect the future growth of the target company it just acquired and does not want to have funded a competitive enterprise by allowing the sellers or other recipients of material deal proceeds to use sale proceeds to start a competitive enterprise post-transaction. Restrictive covenants provide the private equity buyer with assurances that it will have sufficient time to establish itself as a new owner without risk of the prior owner creating a competing business by leveraging its and the target company’s existing contacts and relationships to attempt to convince its prior customers and other key business contacts to move business away from the target company post-transaction.

Further, in highly technical industries, the confidential information or intellectual property of the target company is extremely valuable and may have been one of the largest factors behind the valuation that the private equity buyer was willing to pay for the target company. Protecting such intellectual property or information through robust confidentiality and non-disclosure provisions is essential to maintain the value of the asset and protect future growth. For example, if the private equity buyer acquired a target company that relies heavily on trade secrets (i.e., the proverbial “secret sauce”) and the sellers who knew all those trade secrets are not bound to maintain the confidentiality of such trade secrets, such sellers may intentionally or inadvertently share such information with another party, immediately negating a significant portion of the newly acquired target company’s value and leaving the private equity buyer with no recourse against such sellers.

Finally, in a scenario where a vindictive seller feels it was mistreated in the course of the transaction, confidentiality, non-use and non-disparagement covenants restrict the use and dissemination of confidential information about the newly acquired company and protect against disparaging comments intended to harm the target company and/or the private equity buyer. The potential damage that disparaging comments can cause varies depending on the industry and is most pronounced if the target company operates in a specialized industry or narrow market where such seller has significant business connections, as discussed above.

III. Typical Restrictive Covenant Regime in Transaction Documents and Key Considerations

Private equity buyers have several avenues to impose restrictive covenants on sellers and other recipients of material deal proceeds and other key personnel: non-disclosure agreements, purchase agreements, limited liability company agreements, partnership agreements or stockholder agreements, restrictive covenants agreements, incentive equity grants, and employment agreements.

A. Pre-Transaction Non-Disclosure Agreements

Pre-transaction non-disclosure covenants restrict either (1) the buyer unilaterally or (2) the buyer and seller(s)/target company mutually. In the course of evaluating a transaction, private equity buyers expect seller(s)/target company to disclose significant confidential information about a target company in connection with ordinary course business, financial, and legal due diligence. Accordingly, at the outset of any transaction, the buyer, sellers, and the target company will typically enter into a non-disclosure agreement restricting the buyer from using or disclosing any confidential information of the target company that it learns in connection with the transaction other than in connection with evaluating the proposed transaction. If the transaction does not close for any reason, the pre-transaction non-disclosure agreement ensures that the would-be private equity buyer is restricted from using the information it learned about the target company to, directly or indirectly, harm the target company (e.g., using techniques learned in diligence to improve the products or processes of one of its existing portfolio companies).

Sellers, or their bankers, will often present the form of non-disclosure agreement to the private equity buyer for execution prior to the private equity buyer being given the opportunity to evaluate a transaction. These form non-disclosure agreements will often be unilateral in favor of the sellers (i.e., restricting the buyer but not the sellers). In a straight stock or asset acquisition where the consideration is cash, a unilateral non-disclosure agreement may be acceptable. In those transactions, the private equity buyer may not be disclosing any confidential information. If the transaction is structured as a merger or contemplates rollover, such that the sellers will have access to sensitive information of the buyer, it is recommended to discuss with counsel whether a mutual agreement, binding both parties to confidentiality obligations, would be appropriate.

When negotiating a transaction non-disclosure agreement, the private equity buyer should ensure that the non-disclosure agreement includes, at a minimum, the following provisions for its benefit: (i) even in a unilateral non-disclosure agreement, both parties, and their respective representatives, will keep the fact that discussions between the parties are ongoing, including any terms or conditions of the draft agreement, confidential, (ii) that the permitted recipients of confidential information include potential financing sources (whether debt or equity) (noting that equity financing sources often require the prior approval of the seller(s)), (iii) a “dual-hat” carve out which provides that other portfolio companies and affiliates of the private equity buyer will not be deemed to have received confidential information (and thus be subject to the restrictions set forth in the non-disclosure agreement) solely by reason of the representatives of the buyer serving in a management role of such portfolio company or affiliate, and (iv) a “residual knowledge” qualifier which provides that the representatives of the private equity buyer will gain additional general industry knowledge as a result of the transaction, including from access to the sellers’ confidential information, and that such representatives will be permitted to use such general knowledge without restriction.

The non-disclosure agreement and the applicable purchase agreement each typically provide that the non-disclosure agreement shall terminate automatically upon closing of the transaction and the purchase agreement will impose new restrictions on the seller with respect to confidential information or, if a transaction does not occur, between eighteen to twenty-four months from the effective date of such non-disclosure agreement.

B. Purchase Agreements

The purchase agreement will often include robust restrictive covenants, either directly in the purchase agreement or in an ancillary agreement (i.e., a restrictive covenant agreement), intended to bind the sellers and other recipients of material deal proceeds for a period post-transaction and typically include all the covenants discussed above. As noted in the preceding section, the purchase agreement will often provide that the non-disclosure agreement among the private equity buyer, sellers, and target company entered into at the beginning of the transaction is terminated effective upon the closing of the transaction. The sellers, as the prior owners of the company, are privy to all of the confidential information of the target company. Accordingly, a purchase agreement should always include confidentiality and non-use restrictions on the sellers providing that no seller may directly or indirectly, disclose or use any confidential or proprietary information involving or related to the business, subject to narrow exceptions (e.g., as required by law or for tax purposes).

Non-competition covenants are highly desired by private equity buyers in the purchase agreement to protect the buyer’s new asset. However, because such covenants impose restrictions on the sellers’ and other recipients of material deal proceeds’ ability to operate freely, non-competition covenants are often limited or narrowed by sellers and state law. For purposes of non-competes in the purchase agreement, a key exception to the limitations on the restrictions under most state laws is the “Sale of Business” exemption. A “Sale of Business” exemption provides that non-competes are permitted when such non-compete restriction is entered into in connection with a sale of a business in exchange for sufficient consideration. Sellers and other recipients of material deal proceeds will resist non-competition covenants generally. A seller who is planning to retire, who the private equity buyer intends to keep engaged following the closing of the transaction or who is rolling equity, may not be as concerned with such restrictions because such seller was not planning to compete regardless, or, in the case of rollover, such seller has an economic interest in ensuring the continued success of the business and, therefore, such rollover seller’s interests should be aligned with the private equity buyer. A large strategic seller or private equity seller with other assets in similar industries may insist that non-compete language be removed from the purchase agreement because such restriction would impair its ability to continue other operations. In such situations, the private equity buyer may have to impose restrictions on certain individuals through different means (i.e., restrictive covenants agreements with founder sellers) or narrowly tailor the non-compete provision in the purchase agreement to only restrict operations in the specific geographic area or niche area that the sellers are exiting by selling the target company (or agree to a specific no-buy list), as discussed above.

Non-solicitation/non-interference of customers/business partners and non-solicitation/no-hire of employees/service providers and non-disparagement covenants in the purchase agreement also provide additional protections to private equity buyers but are usually less controversial. Sellers may narrow a non-solicitation covenant to include certain common carve-outs (e.g., key employees only) or shorten the period of time it must comply with the covenant. A strategic or private equity seller may want to be free to hire individuals that it had formed relationships with while operating the business but the private equity buyer should have comfort that the sellers will not poach its key employees immediately post-transaction and, unlike non-compete provisions to which private equity sellers typically do not agree to, non-solicitation provisions are usually binding on such sellers. If there are certain individuals who a seller wishes to retain, such retention should be explicitly negotiated and provided for in the purchase agreement. If any seller strongly resists a non-disparagement covenant, a discussion should be had to understand the seller’s intent (i.e., does such seller plan to disparage the buyer post-transaction). Sellers often insist on non-disparagement covenants to be mutually binding on the private equity buyer, however, such mutuality may not always align with such buyer’s interest in freely operating the newly acquired company and its other portfolio companies. A private equity buyer likely operates many portfolio companies and agreeing to restrictive covenants may make compliance and tracking difficult across its platforms (if the mutual restriction applies broadly to affiliates), so it is recommended to consult with counsel to determine whether mutual non-disparagement is reasonable in a given transaction.

C. Operating Agreements/Profits Interests Grant Agreements/Restrictive Covenants Agreements

Many private equity buyers use “rollover” to fund a portion of the purchase price (i.e., reduce the equity check). Deals structured with rollover not only provide sellers with a cash payment for a portion of their equity in the target company at the closing of the transaction, but they also give the rolling sellers the opportunity to continue investing, directly or indirectly, in the company’s future value by receiving equity in the post-transaction platform company. Often rollover equity is structured on a tax-deferred basis, and is intended to ensure that the sellers have a continued interest in the growth of the company and an incentive to remain engaged, directly or indirectly, post-transaction. In addition to historical information regarding the company, a rollover seller is likely to obtain confidential information about the company following the closing of the transaction (e.g., via a seat on the board, access to financial reports, etc.). Ownership of rollover equity by a seller gives the private equity buyer the opportunity to impose additional restrictive covenants tied to the applicable seller’s ownership of the platform company. Accordingly, such restrictive covenants are typically included in an operating agreement (or equivalent) for the platform company and impose a similar scope as the non-competition covenants in the purchase agreement (but the survival of such covenants will often last for as long as the equity holder continues to hold equity in the platform company, plus, potentially, a tail period).

In addition to rollover, if the investment holding company is a limited liability company, a private equity buyer will often grant profits interests (or other incentive equity) to sellers who continue to provide services to the target company and key employees of the target company. Profits interests are a form of equity interest in the platform company that entitle the holder to a share of sale proceeds in excess of the invested capital. While also being a generous and tax-efficient way to compensate key contributors to the target company and incentivizing such key contributors to further the growth of the target company, profits interest grants provide a means to bind key personnel who were not sellers at the closing of the transaction and do not otherwise own equity in the platform company to restrictive covenants. Profits interest grants are membership interests and, accordingly, the recipient must sign a joinder to the operating agreement and agree to be bound to any restrictive covenants contained therein as a member. In addition to the joinder, a private equity buyer will often condition the profits interests grant on the recipient executing a separate restrictive covenants agreement which provides that, for so long as the recipient is employed by the target company or its affiliates plus, potentially, a tail period, such recipient shall comply with the restrictive covenants detailed therein.

A word of caution: A private equity buyer should take care that it, and its personnel, are properly carved out from any restrictive covenants in operating agreements. As equity holders of the platform company, absent a carve-out, the private equity buyer and any personnel that have received profits interests grants in connection with their work with the platform company will be subject to such covenants which could inadvertently restrict the private equity buyer’s ability to continue its other operations whether it’s buying and selling other platforms or operating its other businesses in the ordinary course.

D. Employment Agreements

Employment agreements provide a private equity buyer with yet another potential avenue to bolster its protections in the value of the acquired business. As an initial matter, restrictive covenants in an employment context must first be analyzed through the lens of applicable state law. Some states such as California ban certain employment related restrictive covenants such as non-compete covenants as a matter of public policy. Other states have legislated specific substantive parameters and process requirements. For example, Massachusetts permits non-compete covenants for no longer than one-year following certain terminations of employment and only if “garden leave” or other mutually agreed consideration is provided. It is also important to understand any “grandfathering” provisions under state law which may allow covenants in place prior to enacted legislation to continue in force if undisturbed.

Employment related restrictive covenants, if permissible, generally can provide the benefit of preserving protection beyond the fixed-time purchase agreement protection. That is, after the typical three to five year sale of business restrictive covenants expire, an employee subject to an employment-related restrictive covenant can remain bound for the period of employment and a reasonable tail period beyond. Further, unlike the purchase agreement covenants which are typically required to be narrowly tailored in scope to the business being acquired as of the closing of the transaction, employment-related covenants can be drafted to capture the evolving business of the platform. For this reason, it is important that a private equity buyer diligence existing employment related restrictive covenant agreements and employment agreements, consider applicable state law limitations, and develop a framework that works to supplement purchase-related and equity-related covenants.

IV. Enforcement, Potential Issues & Recent Changes

A. Injunction/Specific Performance

Breaches of restrictive covenants can lead to significant harm to the non-breaching party. Recall the example of a company which relies significantly on trade secret protections. If a seller shares such trade secrets post-transaction, the value of the target company may be significantly diminished by copycat versions of its product. In breaches such as this, or where a seller is threatening to breach, money damages in the event of a breach would be difficult to enumerate and would not be sufficient to compensate the non-breaching party for the severe impact to its business. Accordingly, every agreement including restrictive covenants should provide that, in addition to monetary damages, the non-breaching party is entitled to equitable relief in the form of an injunction (i.e., a court order preventing the breaching party from continuing such breach) or specific performance (i.e., a court order forcing the breaching party to perform an action required by the agreement).

B. State and Federal Law

Restrictive covenants, and more specifically, non-competition covenants, have been a topic of discussion at state and federal levels. Each state takes its own approach regarding the enforceability of non-competition covenants, with California arguably being the strictest. Historically, there has not been any generally applicable federal rules with respect to restrictive covenants; however; in 2024, the Federal Trade Commission (FTC) issued a rule to ban most post-employment non-competition agreements. Later in 2024, the courts held that the rule could not be enforced or otherwise take effect. While the FTC rule has been set aside, it is worth noting that these types of restrictive covenants are being considered at the federal level along with an ever-shifting patchwork of state and local laws. For more details regarding non-competition restrictions and the FTC rule, please see the additional materials linked below.

• Practical Policies - Non-Competes: Are They Still a Thing?
• What the FTC’s New Rule on Non-Competes Means for M&A and Private Equity Transactions

V. Conclusion

Restrictive covenants will always be an important piece of any private equity transaction to ensure that a private equity buyer is protecting its investment to the fullest extent possible. Whether as a buyer or a seller in these transactions, understanding the scope and limitations of such covenants is important. The Mintz Private Equity and Employment practice groups are continuously monitoring developments with respect to restrictive covenants and are available to assist private equity sponsors and sellers in drafting, negotiating and enforcing their rights pursuant to any restrictive covenants.

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