Under What Circumstances are Noncompete Covenants Enforceable Under California Law?
Under California law, noncompete covenants are generally unenforceable due to California’s strong public policy against restraints on trade. However, there are certain narrow circumstances in the employment context and in connection with a sale of a business in which noncompete covenants may be enforceable.
One exception to the general rule that noncompete covenants are unenforceable under California law applies in the context of the sale of a business. Under California Business and Professions Code §16601, in certain circumstances, any person who sells (i) the goodwill of a business, (ii) of all of his or her ownership interest in the business entity, or (iii) all or substantially all of the operating assets of a business, together with the goodwill of the business, may agree to refrain from carrying on a similar business. The legislature enacted this exception because it reasoned that once the goodwill of a business is sold, it would be unfair to permit the seller to engage in competition which diminishes the value of the assets sold. In order to enhance the enforceability of any such noncompete, the parties should (a) include a clear indication that in the sale transaction the parties valued the goodwill of the business in determining the sales price and (b) make sure that in a transaction involving the sale of ownership interests, the owner of the business sells all of his or her ownership interests in the business entity.
In the employment context, noncompetes are generally enforceable during the term of employment but are generally unenforceable following termination of employment. However, some California courts have held that certain post-termination restrictive covenants are enforceable when necessary to prevent a former employee from revealing trade secrets to competitors. In particular, California courts have held that restrictive covenants that are specifically designed and narrowly tailored to protect trade secrets may be enforceable. Accordingly, courts would not likely uphold a traditional noncompete covenant that is limited to a specific time period and/or geographic area but may consider upholding, for example, a noncompete covenant that prohibits a former employee from competing for the business of specific customers that the employee learned about during his or her employment for a certain period of time following termination.
What Scope, Time and Geography Limitations on Noncompete Covenants have been found to be Enforceable under California Law in Connection with a Sale of Business?
While not expressly stated in the language of the statue, California courts have held that a noncompete covenant in connection with the sale of a business is only enforceable to the extent it is reasonable and necessary, in terms of its scope, time and geography, to protect the buyer’s interests. In any specific case, the reasonableness of a noncompete covenant will require the balancing of the interest of the entity protected, the person restrained, and the general public. With respect to the scope of the activities prohibited, §16601 California Business and Professions Code permits a prohibition on “carrying on a similar business.” Generally speaking, courts have held interpreted this language to mean that a noncompete covenant will cover direct or indirect transactions or solicitation of substantial business activities in competition with the buyer (i.e., single or isolated transactions in competition with the buyer are not prohibited). With respect to geographical scope, the noncompete may limit competition in any area where the business is carried on, including production, promotional and marketing activities (i.e., not just where the business has physical locations). Finally, with respect to temporal scope, the statute provides noncompete is enforceable for so long as the buyer continues to carry on the business. In applying the statute, California courts have been willing to uphold noncompete covenants for as long as five years under the right circumstances.
Gaurav Krishan is an attorney with Stubbs Alderton & Markiles, LLP. Gaurav’s practice specializes in corporate transactions, including M&A, dispositions and recapitalizations, private equity transactions, and general corporate matters for both public and private clients, focusing on startup and emerging growth companies. You can contact him at Gaurav Krishan at firstname.lastname@example.org or (818)444-4516. This was originally published on the firm's blog.