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Restrictive Covenants in Purchase/Sale Agreements and Employment Agreements

Presentation at AVMA Convention in Seattle, Washington in August 2009

by Peter S. Lewicki 

 

 

I.               Introduction.

 

A.    Reasonable restraints of trade, as a way of protecting valuable good will accumulated over a long span of time by the seller, vs. refusal to allow unlawful restraints of trade which are unenforceable for a variety of reasons:

1.     Unequal bargaining power between employer and employee;

2.     Freedom of the client to select a veterinarian of their choice.

3.     In most cases, an employer will be able to freely contract with her or his employees and include a well drafted non-competition agreement,  non-solicitation agreements (both as to clients and other employees of the practice), and non-disclosure arrangements. The Appendix has sample language for to illustrate these forms of agreement. Caveat:  the use of these forms in drafting of employment agreements containing these or similar restrictive covenants is only for purposes of illustrating the materials in this outline. Use of these forms is to be made only with the advice of local legal counsel qualified in this area of the law.

 

4.     Some states (e.g., California) totally prohibit the use of a non-competition clause in the employment contract of an employee, while permitting a non-compete clause to protect the good will of a buyer who purchases it from a seller who potentially could destroy the good will sold to the buyer by re-establishing a practice nearby the old location and within a short interval of time.

 

 

B.             Sale and Purchase of veterinary medicine practices.

 

1.     From seller’s perspective:

a.              Seller will be able to allocate a very significant portion of the sale price for the practice to what are termed “intangibles”, including good will, covenant not to compete and covenant precluding solicitation of former clients post sale;

b.              Seller’s allocation will be entitled to long-term capital gains treatment (currently a 15% marginal tax bracket as contrasted with ordinary income tax rates of up to 35% currently.

 

 

2.     From the buyer’s perspective:

 

a.              The buyer will be able to deduct or “write off” over a special 15-year period, all of the good will (including amounts allocated to covenant not to compete), in equal annual (1/15) deductions, eg., $150,000 allocated to good will and other intangibles able to be written off in $10,000 installments against income of the practice.

 

3.     Contrast the Current Tax Ramifications with the Past:

 

a.              The previous practice was to set up a time consuming and uncertain negotiation between the buyer and seller, each of whom would have competing and opposite interests in maximizing the allocation to good will (the seller), while the buyer would have negotiated as high a value as possible to the non-competition agreement (being able to write off against ordinary income

 

4.     Valuation and Related Issues:

a.              The parties to a sale will want to approach the process of price discovery by looking at the practice from the standpoint of cash flow, profitability, and to a lesser extent the value of the hard assets (furniture, fixtures and equipment, “F, F & E”).

b.              However, a critical part of this process will be to carefully examine the relationship of the seller’s employees, particularly non-owner veterinarians, and whether they are subject to an existing non-competition agreement

 

5.     Allocations.

a.              Drawing a distinction between a corporate good will asset allocation and the personal good will of the individual veterinarian who owns the stock of the entity which is the operating vehicle conducting the practice.

b.              Sub-S Corporation issues versus “C Corporation” accumulated earnings which hide a substantial double taxation impact unless a substantial amount of the consideration paid for the practice is allocated to personal good will as contrasted with a blanket allocation of all good will to the seller (i.e., the seller’s corporately owned practice).

c.              Factors which bear on the amount of allocation for good will to the individual versus what should be allocated to the employer.

 

6.     Communications with employees, with veterinarian employees, with staff, and with the public.

a.              Timing

b.              Content

 

7.      Actual Case studies.

a.              “As the crow flies:”

(1)   Illustrates the importance of careful drafting, by the omission of the word, “radius” from the text of the non-competition agreement, e.g. “Ten miles from the location of the veterinary medicine practice.”

(a)   Question: is this “as the crow flies” as in normally encountered contexts (for example, including the word, “radius” as a modifier to “…a radius of ten miles from the location of the veterinary medicine practice….;” or,

(b)  Is it ten miles as normally traveled by road from the reference point to the location of the veterinary medicine practice?

(2)   See Appendix attached

 

 

b.              Close calls (9 ½ miles close to 10?)

c.              Date of employment versus date of signing of employment contract.

d.              Are all currently employed vets (‘on board”) for the transition? Who is not committed? Will they sign a new employment agreement, with the new employer, prior to the transaction closing? If not, are there protections that the purchaser can employ?

e.              Trade Secrets Act aspects.

(1)   Safeguarding of both electronic and hard copy medical records, and client and referral source information.

(2)   Issues regarding post sale contact by former employees of veterinary medicine practice purchase. Right way and wrong way to accomplish both the freedom of the clients to select the veterinarian that they want, versus the need to protect the valuable good will of thepractice which has been purchased for substantial value.

(3)   Non-solicitation agreements as contrasted with non-compete arrangements.

a.     “Blue pencil” approach taken by the judges of many jurisdictions (in effect, allowing a “second look” and re-drafting the agreements reached between the parties).

b.     Non-compete arrangements as an exception to the general legal principal of freedom of contract and rules regarding prohibiting “restraints of trade.”

 

 

B.             Employee Relationships and employment agreements.

 

1.                  Courts are much more reluctant to restrict employees’ ability to move to other locations and practice veterinary medicine in a new place, than they are in adjudicating between buyers and sellers, where there are very good policy reasons to protect the investment of time and money in a practice.

2.              Distinction between covenant not to compete and non-solicitation agreements.

3.              Radius and length of time as measuring the scope of the restriction.

 

 

C.              Litigation versus mediation/arbitration in the context of non-judicial dispute resolution.

1.     Litigation;

2.     Expense, and the factors relating to determining if the “game is worth the candle.”

3.     Injunctive relief (TRO’s, preliminary and permanent injunctions).

4.     Indemnity Bonds required to pursue injunctive relief in most cases.

 

III.       Conclusion

                      

                       At the end of the day, every situation is different, and there is no “cook book” methodology to forming effective, fair and productive employer/employee relationships regarding use of restrictive covenants.  However, once these relationships are structured around fair, well written and thoughtful employment agreements, the parties to the agreements will be far ahead of the competition, so that everyone knows his or her relationship to the veterinary medicine practice, with no uncertainties clouding that relationship. Fairness is a key element as it is in all human relationships.


 

APPENDIX[1]

 

A.        Sample Non-Competition Clause:

 

  Non-competition Covenant and Agreement.  Employee and Employer agree that Employer’s practice and business is local in scope and that it would suffer serious damage and loss of goodwill if, upon termination of the employment relationship, Employee competed with Employer by providing veterinary medicine services for clients of Employer.  It is understood that the restrictions required are necessitated in part because of the time, effort, and resources required to develop Employer’s business (either as purchased from its previous owner. or by the Employer itself, or developed or to be developed in the future), its continued development and maintenance, and in the event that the employment relationship is terminated, the additional time and effort to replace and train a new replacement employee.

            1.         Therefore, in consideration of the compensation and benefits that Employee will receive, and in exchange for the professional education, experience, and training to be obtained while working for Employer, Employee agrees that for a period of eighteen (18) months after the termination, for any reason, of the employment relationship, Employee will not provide veterinary services for Clients as an Employee of any competing business or professional veterinary medicine practice located with a five (5) mile radius of Employer’s place of business at [address].  Employee further understands and agrees that for a period of eighteen (18) months after termination of employment, for any reason, Employee will not develop, open or have any role in the creation of any competing business or professional veterinary medicine practice with a five (5) mile radius of Employer’s place of business at [address].  For purposes of this Agreement, it is agreed and understood that the term “competing business” is defined to mean any person or entity engaged in the business of operating a small animal [or large animal, equine, etc.] veterinary medicine hospital or clinic(s).

 

 

 

B.        Sample Non-Solicitation of Clients Agreement.

 

            Non-solicitation of Employer’s Clients Covenants.

1.         Employee agrees that by reason of his or her employment with Employer, Employee has, or may come into contact with some, most or all of Employer’s Clients and their Patients, as well as learn or have access to Employer’s Trade Secrets and Confidential, Proprietary Information regarding Employer’s Clients.  Employee further agrees that loss of Employer’s Clients will cause Employer to suffer great and irreparable harm.

  2.       Employee agrees that in the event of termination of employment by Employer, whether voluntary or involuntary, and for any reason whatsoever, Employee will not:

•  solicit or seek veterinary medicine Clients, or perform any of the services performed by Employer for any Employer Client, either individually or as an employee or principal of another veterinary medicine practice (or in association with, or in conjunction with another veterinary medicine practice),

  provide services to any Client, nor shall said Employee directly or indirectly, for the Employee or on behalf of or in conjunction with any other person, nor cause or permit any other person, firm or entity, to solicit, divert contact, or take away any such Client of Employer during the term of this employment.

The period of time during which this Non-Solicitation Agreement is in effect shall include a period of three (3) years following termination of Employee’s employment with Employer for any reason whatsoever.

3.         Neither shall Employee own, manage, operate, join, control, be employed by or participate in the management, ownership, operation, or control of, or be connected in any manner with any business which attempts to do what Employee is hereby prohibited from doing  (or in association with or in conjunction with another veterinary medicine practice). 

4.         Within the circumscribed period of three (3) years with respect to this Non-Solicitation Agreement, Employee shall, however, be permitted to participate in, or be otherwise employed or associated with a competing firm, so long as no information is disclosed by Employee as to Clients or other Confidential Information prohibited from being disclosed under this Agreement.  Employee agrees that this Non-Solicitation Agreement is of great importance to Employer and constitutes a primary aspect and feature of this Agreement.

            5.         The parties agree that soliciting of business includes, but is not limited to, in-person, written, telephone, e-mail or other forms of electronic communication, or contact of any kind with any Client, either in a business context or in a personal relationship context.

C.        Sample Non-Solicitation of Employer’s Employees Agreement.

 

1.         Non-solicitation of Employees.  Employee agrees that he or she will not, during the term of employment with Employer and for an additional period of one (1) year thereafter, either voluntarily or involuntarily, directly or indirectly, individually or in connection with third parties, induce or attempt to persuade any employee, agent, manager, consultant, director, or other participant in Employer’s practice to terminate such employment or other relationship in order to enter into any relationship with Employee, any business organization in which Employee is a participant in any capacity whatsoever, or any other business organization in competition with Employer’s practice.

 

D.          Miscellaneous Provisions Necessary to Provide Remedies in the Event of Breach.

 

1.         Enforcement.  Employee agrees that compliance with the provisions of paragraphs relating to the Restrictive Covenants of this Agreement is necessary to protect the business and goodwill of Employer.  Any breach of paragraphs [itemize paragraphs] will result in irreparable and continuing damage to Employer, for which money damages will not provide adequate relief.  Accordingly, Employee agrees that in the event he or she breaches, or threatens to breach paragraphs [itemize paragraphs] of this Agreement, in addition to any other legal or equitable relief to which Employer may be entitled, Employer shall be entitled to temporary, preliminary or permanent injunctive relief, without proof of actual damages sustained by Employer as a result of said breach or threatened breach.  If Employee breaches any obligation under this Agreement, Employee will pay to Employer in addition to any damages sustained by Employer, the attorneys’ fees and other costs described below incurred by Employer in establishing breach and in otherwise enforcing the terms of this Agreement.

 

            2.  Damages.  The parties agree that it would be difficult, if not impossible to determine the damages to Employer in the event of a breach of this Agreement.  A breach of this Agreement will deprive Employer of the income from the Clients after Employer has invested substantial resources in establishing and maintaining those Clients. Therefore, to eliminate any uncertainty as to the amount of damages sustained by Employer in the event of a breach of this Agreement, and not intended as a penalty imposed against the former Employee, the parties agree that the Employee shall make the following payments to Employer:

a.         First Year Following Termination.  Employee shall pay to Employer x% of the annual Client fees received by Employee or Employee’s new employer over the twelve (12) month period ending with the date that Employee first commences rendering services to any Client following termination of employment with Employer;

b.         Second Year Following Termination.  Employee shall pay to Employer, y% of the annual Client fees received by Employee or Employee’s new employer over the next twelve (12) month period ending with the date that Employee first commences rendering services to any Client following termination;

c.         Third Year Following Termination.  Employee shall pay to Emplyer, z% of the annual Client fees received by Employee or Employee’s new employer over the next twelve (12) month period ending with the date that Employee first commences rendering services to any Client following termination;

d.         Payments Due Schedule.  Employee shall pay all amounts due under this paragraph, in twelve (12) installments, with 50% of the total amount due being paid by Employee to Employer within forty-five (45) days following the commencement date of rendering such services following termination, and the balance payable in eleven (11) equal installments of principal, together with interest at the legal rate of 12% per annum on the declining principal balance with respect to each such installment.

           

3.  Separate Representation or Opportunity of Same.  Employee has been advised by Employer  and Employer’s legal counsel, [Insert Attorney’s Name and Firm] that it does not represent Employee in connection with this Agreement.  Employee should seek independent legal advice in connection with the negotiations, drafting and legal effect of this Agreement as it relates to his or her employment with Employer, particularly paragraphs [itemize paragraphs].  Employee acknowledges that he or she has been given a reasonable opportunity to seek and receive independent legal counsel’s advice on this Agreement prior to execution.

 

4.  Attorney’s Fees and Venue.  In the event that it becomes necessary to interpret or enforce the terms of this Agreement, the prevailing party in any such proceeding shall be entitled to recover a reasonable attorneys’ fee and all costs of suit including expert witness fees, deposition costs (including transcription fees), filing fees, service of process fees and other miscellaneous costs incidental to that litigation.  Venue for any such suit is hereby agreed to be in [Insert Name of Local Court].

 

5.  Survival of Non-Solicitiation and Nondisclosure of Confidential, Proprietary Information and Non-Competition Agreement After Termination of Employment.  The parties agree that the covenants against Non-Solicitation, Disclosure of Confidential Information, Non-Competition Agreement and the remedies pertaining thereto shall survive any termination of this Agreement.

 

6.  Severability.  If any provision of this Agreement or the application of it to any party or circumstance shall be held by a court of competent jurisdiction to be invalid and unenforceable to any extent, the remainder of this Agreement shall not be affected; such provision shall be deemed to be amended to the maximum extent enforceable by such court, and all other provisions shall be valid and enforceable to the fullest extent permitted by law.

 


[1] These illustrative forms are provided only for purposes of demonstrating the type of similar arrangements often made in connection with the employment agreements between veterinary medicine practices and professional non-owner veterinarian employees.  Each state’s laws vary in regard to the enforceability of such agreements and the language of the employment agreements which are permissible in a particular jurisdiction. Therefore, the use of these illustrative forms is only recommended after consultation with local legal counsel of your particular state or jurisdiction.

© Peter Lewicki 2012