Covenants not to compete as part of purchase and sale transactions.
By Paul J. Welk, PT, JD
As loyal readers of Impact magazine have certainly noted over the past number of months, there is significant activity involving physical therapy practice acquisitions. In connection with these transactions, a number of documents are negotiated and executed including letters of intent, purchase and sale agreements, employment agreements, promissory notes, and others depending on the terms of the specific transaction. While all of the terms of the transaction are important to the parties, one of the most frequently negotiated provisions is the covenant not to compete (“noncompete”) entered into by the selling physical therapist. This article will explore, through the use of a case example, the basics of a noncompete, including its common elements, the difference between noncompetes in purchase agreements and employment agreements, and common positions taken by buyers and sellers in connection with the negotiation of such documents.
Let us consider the case of a practice owner, Christine, who owns Superstar Physical Therapy, Inc. Superstar operates two locations, one in Smalltown and one in Bigtown, and has been owned by Christine for 20 years. At the closing of a sale transaction in which Christine sells all of the shares of Superstar to the buyer, Christine enters into a purchase agreement that contains a five-year noncompete starting from the date of closing. This noncompete prohibits Christine from providing physical therapy services within a 25-mile radius of any location of Superstar in operation as of the closing (i.e., Smalltown and Bigtown). Additionally, Christine enters into a new employment agreement at the closing, which contains a two-year noncompete and begins on the date of termination of employment. This noncompete prohibits Christine from providing outpatient physical therapy services within a ten-mile radius of any practice location of Superstar at which Christine provided services during her employment.
With that factual scenario as background, we can now consider certain issues. As general background, the enforceability of a covenant not to compete is typically analyzed under state law through the court system. The question of enforceability generally arises if a party violates the terms of a noncompete, for example, if Christine became unhappy with the buyer and opened a new clinic two miles from Superstar’s Smalltown clinic six months after the closing of the sale transaction. Certain states disfavor covenants not to compete while other states favor a freedom of contract approach and are more likely to enforce a contractually negotiated noncompete. While each state analyzes the enforceability of a noncompete differently, in general the enforceability is based on whether the restraints in a particular situation are reasonable based on the specific facts.1 Covenants deemed unreasonable by a court during litigation are typically either reduced in scope by the court to terms that it believes to be reasonable or are deemed to be null and void. By way of example, if Christine’s noncompete in her employment agreement was for a period of 5 years and 100 miles and lawsuit alleging a violation were filed, many courts would presumably question whether such a restraint is reasonable. A noncompete that is deemed enforceable by a court during the litigation process is subsequently enforced, often through a payment of damages by the violating party or by the court ordering the violating party to cease the conduct in violation, a process often referred to as an injunction.
When considering noncompetes in a purchase agreement and associated employment agreement, as noted above these noncompetes are not mutually exclusive and generally contain different terms. When examining these two types of noncompetes, it is important to understand why the differences exist. It has long been recognized that noncompetes executed in connection with a purchase and sale agreement are not subjected to as rigorous a reasonableness examination as noncompetition covenants ancillary to an employment contract.2 As a result, the terms of a purchase agreement noncompete are often more restrictive. This underlying legal premise is consistent with the business reasons behind the noncompete. More specifically, a buyer who purchases a physical therapy practice generally expects a covenant not to compete to contain broader restrictions in consideration of the purchase price being paid to the seller. In today’s market, it would not be uncommon for a buyer to advocate for a five-year noncompete in a purchase agreement. This requirement is in consideration for the buyer paying a significant price for the practice and needing to preclude the seller from competing in the market for a sufficient period of time to allow the buyer to receive the benefit of the transaction. By way of example, if Christine received the purchase price payment for Superstar and one year later was able to reenter the market without restriction, the buyer would presumably not receive the full value of the practice as Christine’s goodwill in the community would likely be a significant benefit to her new practice.
In looking at the key terms of Christine’s noncompetes, the issues presumably negotiated relate to scope, term, and area. Scope addresses the breath of the restrictions in place. As to scope in Christine’s case, the purchase agreement noncompete broadly references physical therapy services as opposed to private practice physical therapy. Practice buyers often advocate that this broad restriction better incentivizes the selling physical therapist to remain fully committed to the buyer for a period of time following the closing. Additionally, a buyer frequently justifies a broader noncompete given the fact that this is a business sale rather than an employment relationship and a material payment has been made to the seller. The restriction in the employment context is often more narrow, as in Christine’s case, which limits the restriction to outpatient physical therapy services rather than physical therapy generally. This noncompete would presumably allow the individual to provide services in a skilled nursing facility following a termination of employment as this is a setting not typically deemed to be in competition with a private practice.
Term relates to the number of years or months for which the restriction applies. In this case, the restriction in the purchase agreement runs for a period of five years and the restriction in the employment agreement runs for a period of two years. Should the employment relationship be terminated within the initial five-year period, there is presumably a time in which the restrictions run concurrently. From the buyer’s perspective, the noncompete contained in the employment document is of significant value should the employee terminate employment after the purchase agreement noncompete has expired. When considering noncompete restrictions employment context, it may also be appropriate to consider whether there are certain circumstances in which the duration would be decreased or the restrictions otherwise limited. For example, an employment agreement noncompete may contain a provision stating that if the employee terminates employment for cause (such as due to the breach of the employment agreement by the employer), the employment agreement noncompete would no longer be in effect. However, such a set of circumstances generally would not void a purchase agreement noncompete where the supporting rationale for the restrictions, payment of the purchase price, remains. From a term perspective, the noncompete period in the purchase agreement typically runs from the date of closing, while the noncompete in the employment agreement typically runs during the employment period and for a fixed period of time from the date of the termination of employment.
Area relates to the geographic area in which the restriction applies. As to the geographic area restriction, the mileage restriction is generally more in the context of the purchase agreement, in consideration of the purchase price payment made to the seller. Another key distinction in the two noncompetes is the location from which the geographic restriction applies. In this example, the restriction in the purchase agreement is limited to the two locations in operation at the time of the transaction closing. When negotiating the noncompete in a transaction, consideration should be given to how additional locations may affect the restrictions in the noncompete. For example, it may or may not be appropriate to include a noncompetition restriction based on a mileage radius from newly opened clinics. In considering the employment agreement noncompete, note that while the geographic restriction is less on a mileage basis, the locations have the potential to be broader if, for example, Christine provides services at multiple newly opened Superstar locations other than those in Smalltown and Bigtown.
When considering covenants not to compete in purchase-and-sale transactions, it is important to consider the rationale behind the restrictions and the interests of the respective parties in negotiating the noncompete terms. As illustrated earlier, there are many elements in a noncompete that are generally subject to negotiation, and it is important to consider each of these, as well as others depending on the particular transaction, in negotiating these provisions.
1. Ruhl v. F.A. Barlett Tree Expert Co., 245 Md 118 (1967).
2. See Worldwide Auditing Services v. Richter, 587A.2d 772, 777 (Pa. Super Ct. 1991).
Paul J. Welk, PT, JD, is a Private Practice Section member and an attorney with Tucker Arensberg where he frequently advises physical therapy private practices in the areas of corporate and health care law. He can be reached at email@example.com.