What Restrictive Covenant Agreements Are in Mergers and Acquisitions
Restrictive covenant agreements in M&A transactions are contractual promises designed to protect the value of the business being acquired. They typically include a combination of non-compete, non-solicitation, confidentiality, non-disparagement, no-hire, and invention assignment covenants. Although these covenants often appear as standard provisions tucked into a purchase agreement or an executive employment agreement, they are among the most heavily negotiated, intensely scrutinized, and consequential deal terms. The enforceability, scope, and tax treatment of these covenants can materially change the economics of a transaction for both buyer and seller.
It is a common misconception that these are “boilerplate” provisions that can be recycled from one deal to another without risk. In reality, state law variation, increasingly aggressive antitrust enforcement, and evolving judicial views on labor market restraints make off-the-shelf approaches dangerous. A clause that is routine in one jurisdiction may be void in another, and a provision that protects a buyer’s bargain in theory can become a litigation magnet in practice. The result is that even seemingly straightforward covenants require bespoke drafting aligned with the target’s business model, workforce, go-to-market strategy, and geographic footprint.
Common Types of Restrictive Covenants Used in M&A
Most deals rely on a toolkit of covenants that serve distinct protective functions. A non-compete seeks to prevent the seller or key stakeholders from operating or assisting a competing business within a defined scope, time, and geography. A non-solicitation provision commonly restricts efforts to solicit customers, suppliers, or employees of the acquired company. Confidentiality obligations protect trade secrets and proprietary information. Additional terms can include no-hire clauses, invention assignment, non-disparagement, and cooperation obligations for post-closing transition.
Although these labels are familiar, the substance matters more than the name. For example, an aggressively drafted customer non-solicitation may be construed by a court as a functional non-compete, triggering stricter scrutiny. Likewise, a “no-hire” clause applied to a broad class of employees can draw antitrust attention if it restrains competition in labor markets beyond what is reasonably necessary to protect the deal. The best practice is to align each covenant with the specific competitive risks and to ensure that every restraint is narrowly tailored to protect identifiable goodwill purchased in the transaction.
Key Enforceability Principles: State Law, Reasonableness, and Blue-Pencil Rules
Enforceability is primarily a function of state law. Some jurisdictions, such as California, North Dakota, and Oklahoma, broadly prohibit non-competes in the employment context with limited exceptions. Many other states permit reasonable covenants incident to the sale of a business if the restrictions are no broader than necessary to protect legitimate business interests, such as purchased goodwill and trade secrets. What is “reasonable” varies widely, and courts examine the business realities: actual markets served, definable territories, the role and knowledge of the restricted party, and the duration required to transition customer relationships.
Courts frequently apply “blue-pencil” or modification rules to tailor overbroad covenants to enforceable scope, but not every jurisdiction will rescue sloppy drafting. Some courts will strike an entire provision rather than rewrite it. The takeaway is that reasonableness must be engineered into the initial language. Overreaching to “start high and negotiate later” is generally counterproductive; it can jeopardize enforceability entirely and indicate an anti-competitive purpose. A carefully calibrated covenant tied to specific lines of business, named customers, or substantiated territories tends to fare better if challenged.
Non-Competes in Sale-of-Business Deals: Scope, Duration, and Carve-Outs
In sale-of-business contexts, non-compete agreements are more likely to be enforced than in ordinary employment settings, provided that the buyer can connect the restriction to purchased goodwill. Duration of one to three years is common, but courts will scrutinize longer terms in light of the target’s sales cycle, customer contract length, and integration timeline. Geographic scope should be tied to actual markets; global non-competes should be avoided unless the business genuinely competes globally. Defining the prohibited “business” too broadly invites trouble; the description should map to the target’s revenue lines and foreseeable adjacency risks.
Carve-outs are equally important. These often include the ability to own a modest passive stake in publicly traded companies, continue preexisting minority investments, or operate in noncompetitive divisions. Without deliberate carve-outs, a seller’s unrelated ventures or routine portfolio activities could inadvertently breach the covenant. Buyers should ensure that carve-outs do not hollow out the restriction; sellers should insist on fair room to operate businesses that do not threaten the acquired goodwill. Precision and documentation of underlying business facts are essential to defend the chosen scope.
Non-Solicitation and No-Hire Provisions: Customer and Employee Protections
Customer non-solicitation covenants often present fewer enforcement hurdles than non-competes, but they still must be tightly drafted. Courts may strike provisions that prohibit accepting unsolicited business or that restrict relationships with prospective customers with whom the seller never interacted. A more defensible approach is to limit the restraint to customers with whom the seller had material contact during a defined look-back period, or to customers of the specific business line purchased. Protecting vendor and supplier relationships may also be appropriate, but overbroad “no-contact” provisions can be problematic.
Employee non-solicitation and no-hire clauses are subject to heightened scrutiny due to labor market concerns. Enforcement risks increase if the restriction covers broad categories of employees without regard to role, confidentiality access, or competitive sensitivity. Narrowing the covenant to senior, customer-facing, or highly confidential roles would be more defensible. Some states have enacted statutes limiting or banning no-poach agreements, and antitrust agencies have challenged “naked” no-poach arrangements that are not ancillary to a legitimate transaction. In an M&A context, the restraint should be demonstrably tied to protecting acquired goodwill and limited in duration and scope to survive scrutiny.
Confidentiality and Trade Secrets: The Backbone of Post-Closing Protection
Confidentiality covenants protect information that often represents the bulk of the acquired value: pricing strategies, customer lists, algorithms, source code, manufacturing processes, and M&A deal terms. While these obligations can be indefinite for trade secrets, courts prefer definitions that track statutory language and clearly distinguish trade secrets from ordinary confidential information. Overbroad definitions that sweep in public or readily ascertainable information will erode credibility and may impair enforceability.
Effective confidentiality protection relies on more than contract language. Buyers should maintain robust operational controls post-closing: access controls, data classification, exit interviews, and monitoring. In the event of a breach, the availability of injunctive relief and the ability to show reasonable measures to preserve secrecy can be dispositive. Practically, pairing confidentiality with targeted non-solicitation and invention assignment provisions gives the buyer multiple avenues to protect the business against unfair competition without overreliance on non-compete clauses alone.
Antitrust and Regulatory Scrutiny: Ancillary Restraints and Labor Markets
Antitrust enforcement has intensified around labor market restraints and competitive overlaps. The guiding principle is that a restrictive covenant in M&A must be an ancillary restraint: reasonably necessary to the procompetitive benefits of the deal and no broader than required to protect purchased goodwill. “Naked” restraints that exist outside a legitimate transaction or expand beyond what is needed for integration risk enforcement actions, including civil or criminal exposure in extreme cases.
Practical risk controls include contemporaneous documentation tying each covenant to specific competitive harms avoided by the restriction, duration modeling tied to customer contract terms or integration milestones, and role-based limitations for employee non-solicitation. Buyers and sellers should also calibrate covenants to any regulatory approvals being sought. For example, merger control filings or second requests may highlight covenants that signal market division or labor allocation beyond what is necessary for the deal. Proactive tailoring and legal review mitigate these risks.
Drafting Mechanics: Precision, Definitions, and Carve-Out Architecture
Drafting begins with meticulous definitions. The “Restricted Business” should be identified by reference to specific products, services, and channels actually conducted by the target as of signing or closing, with carefully considered adjacency. If the target plans to exit or expand certain lines, the definitions should address that reality to avoid gaps or overbreadth. Likewise, the “Restricted Territory” should reflect markets served, not aspirational footprints. Where customer relationships rather than geography drive value, consider customer-based restrictions in place of geographic bans.
Carve-out architecture deserves equal attention. Common carve-outs include passive equity holdings below a specified threshold, continued service to legacy portfolio companies, work for affiliates in noncompetitive segments, and permitted de minimis revenue from incidental overlap. Careful exceptions for responding to unsolicited inquiries, general advertising, and government-mandated transitions can reduce dispute risk while preserving the buyer’s core protections. Every carve-out should be evaluated against the core thesis: preserving the purchased goodwill without unduly restricting legitimate, noncompetitive activity.
Remedies and Enforcement: Injunctive Relief, Liquidated Damages, and Tolling
To make restrictive covenants meaningful, the agreement should provide for injunctive relief without the need to establish the inadequacy of monetary damages, where permitted by law. Parties often include stipulations of irreparable harm and consent to temporary restraining orders and preliminary injunctions. However, courts still require a tailored showing, so parties should preserve evidence of competitive harm and customer relationships at risk. Fee-shifting provisions and prevailing party clauses can further shape litigation dynamics, but they must be drafted with care to comply with local law.
Some agreements include liquidated damages for specific breaches, but these must be calibrated to avoid being treated as unenforceable penalties. Tolling provisions that pause the restriction during periods of breach can protect the buyer’s bargain, though they invite judicial scrutiny if they functionally extend a restraint beyond what a court views as reasonable. Strategically, pre-suit notice and cure mechanisms, combined with an expedited arbitration or forum-selection clause, can streamline enforcement while preserving leverage.
Tax Treatment and Purchase Price Allocation: Section 197, Goodwill, and Ordinary Income
Restrictive covenants carry significant tax consequences that are frequently misunderstood. For buyers, amounts allocable to a covenant not to compete are generally treated as Section 197 intangibles amortizable ratably over 15 years. This can be attractive from an after-tax cash flow standpoint. For sellers, by contrast, consideration allocated to a covenant not to compete is commonly treated as ordinary income, not capital gain. That mismatch creates negotiation friction and makes purchase price allocation a critical bargaining point. Parties should forecast the after-tax economics under multiple allocation scenarios.
Because goodwill and going-concern value also fall under Section 197 for buyers, parties may consider shifting value toward goodwill to improve the seller’s capital gain profile. However, this strategy must align with economic reality and withstand IRS scrutiny. Over-allocating to goodwill at the expense of a reasonably necessary covenant can raise audit risk, particularly where competitive threats are clear. In asset deals, these issues also intersect with Section 1060’s residual method and potential anti-churning concerns for pre-1993 intangibles. Early involvement of tax counsel and a defensible valuation analysis are essential to avoid unpleasant surprises.
Executive and Employee Considerations: Fresh Consideration and Onboarding
When key employees or executives are asked to sign new or expanded restrictive covenants at or after closing, state law often requires fresh consideration beyond continued employment. This can include bonuses, equity grants, severance arrangements, or promotion. Relying on the acquisition itself as consideration may not suffice in some jurisdictions, and courts can void covenants lacking adequate consideration. The onboarding process must be meticulously documented, with signed acknowledgments, tailored role-based restrictions, and targeted confidentiality training to protect trade secrets in the transition.
Buyers should align retention incentives, garden leave arrangements where permissible, and post-closing integration plans with the restrictive covenant strategy. A mismatch between incentive timelines and covenant durations undermines enforceability narratives and practical effectiveness. For sellers, clarity on which employees are bound, the specific limitations imposed, and how exceptions will operate in the context of future ventures is essential to avoid inadvertent breaches and claims of tortious interference.
International and Multi-Jurisdictional Deals: Conflict-of-Law and Local Nuances
Cross-border transactions magnify complexity. Many countries impose statutory limits on non-competes, including mandatory compensation payments during the restricted period (for example, a percentage of salary in certain jurisdictions). Some legal systems are less amenable to blue-penciling, and others require precise definitions of protected interests akin to trade secrets. Attempting to impose a single, uniform covenant across multiple countries is often impractical and can jeopardize enforceability everywhere if one-size-fits-all drafting leads to overreach.
To manage this risk, parties typically adopt jurisdiction-specific annexes with tailored restraint scope, duration, compensation, and enforcement mechanisms. Conflict-of-law and forum-selection clauses require careful calibration to avoid being disregarded by courts with strong public policy against certain restraints. Coordination with local counsel is not optional; it is indispensable to ensure that the restrictive covenant framework is both enforceable and operationally feasible in each relevant jurisdiction.
Deal Process Integration: Diligence, Disclosure Schedules, and Closing Mechanics
The path to an enforceable and effective restrictive covenant begins during diligence. Buyers should map the target’s competitive landscape, customer concentration, key employee roles, trade secret hygiene, and history of restraint enforcement or disputes. This analysis informs the necessity, scope, and duration of covenants. Drafts should be socialized early to identify business carve-outs, portfolio conflicts, and executive-specific issues that could derail closing if left to the last minute. Disclosure schedules should identify existing covenants binding the seller or key employees that could conflict with the new restraints.
Closing mechanics should ensure that all required parties execute the relevant covenants: sellers, holding companies, managers, and any affiliates whose post-closing activities could undermine the buyer’s protections. Conditions precedent can include delivery of signed agreements from designated personnel and evidence of adequate consideration. Post-closing integration plans should incorporate compliance steps, monitoring protocols, and documented training so that, if litigation arises, the buyer can demonstrate reasonableness, necessity, and diligent protection of the acquired goodwill.
Common Misconceptions That Create Expensive Problems
Several myths persist in the market and routinely lead to disputes or failed enforcement:
- Assuming a two-year non-compete is “always reasonable.” In many jurisdictions, reasonableness is fact-specific and linked to customer lifecycle, role, and geography.
- Believing customer non-solicitation is categorically easier to enforce. If drafted too broadly, it can be treated as a de facto non-compete.
- Recycling templates without jurisdictional updates. Legislative and judicial developments can render last year’s “market” language unenforceable today.
- Ignoring labor market scrutiny. Broad no-hire provisions can invite antitrust risk if not narrowly tailored to the transaction.
- Overlooking tax payload. Allocation to covenants can significantly change after-tax proceeds for sellers and amortization profiles for buyers.
Each of these misconceptions stems from underestimating the nuance of restrictive covenant law and overestimating the power of form documents. Experienced counsel and tax advisors add measurable value by avoiding these pitfalls through precision drafting, defensible allocations, and documentation that supports the business case for the restraints.
Practical Steps to Strengthen Your Restrictive Covenant Strategy
A disciplined approach improves both enforceability and practical deterrence. Consider the following steps during planning and negotiation:
- Build a factual record that ties each restriction to specific goodwill assets, customer relationships, and trade secrets acquired.
- Right-size duration and territory with empirical data: customer renewal cycles, contract terms, sales timelines, and market maps.
- Use role-based employee restraints and targeted customer lists rather than blanket categories that sweep too broadly.
- Draft carve-outs precisely and stress-test them against likely seller activities and portfolio strategies.
- Align tax allocation with economic reality and prepare a valuation memorandum to support Section 197 and goodwill allocations.
- Adopt enforcement mechanics that emphasize speed: forum selection, injunctive relief stipulations, and tolling provisions within legal limits.
- Implement post-closing compliance protocols: training, access controls, and monitoring to protect confidential information.
These measures require cross-functional coordination among legal, tax, HR, and integration teams. When done thoughtfully, they turn restrictive covenants from a theoretical safety net into a practical, defensible framework that preserves the core value drivers of the deal.
When to Involve Professionals and Why It Matters
Because the law governing restrictive covenants shifts rapidly and varies dramatically by jurisdiction, early involvement of experienced transactional counsel, employment counsel, and tax advisors is essential. Professionals can triangulate among business objectives, legal constraints, and tax optimization in a way that templates cannot. They can also coordinate with local counsel in critical jurisdictions, prepare evidentiary records to support reasonableness, and structure allocations that align with audit-ready valuations.
Engaging counsel late in the process often leads to painful compromises under deadline pressure, including overbroad covenants that are unlikely to be enforced or allocations that erode after-tax value. Conversely, a strategic approach from term sheet through closing ensures that restrictive covenants are calibrated, defensible, and integrated with the larger deal architecture. In M&A, there is rarely a “simple” covenant; there are only covenants that appear simple until they are tested. Investing in rigorous planning and expert guidance is the most reliable way to protect the transaction you worked so hard to consummate.
