There are numerous circumstances in which obtaining a person’s covenant not to compete would be beneficial. However, Colorado, like many jurisdictions, renders covenants not to compete void, except in limited circumstances. Covenants not to compete are considered restraints on trade, and public policy favors granting citizens the right to seek employment and to compete without restraints.
Colorado Revised Statutes prohibit any covenant not to compete which restricts the right of a person to receive compensation for performance of skilled or unskilled labor for any employer, except in the following cases: (1) any contract for purchase and sale of a business or assets of a business; (2) any contract for protection of trade secrets; (3) any contractual provision providing for recovery of the expense of educating and training an employee who served less than two years; and (4) executive and management personnel and officers and employees who constitute professional staff to executive and management personnel.
Statutes also make void a provision of an employment, partnership or corporate agreement between physicians restricting a physician’s right to practice medicine upon termination of such agreement. But all other provisions of such an agreement, including required payment of damages in an amount reasonably related to injury caused by termination of the agreement, are enforceable. Provisions requiring payment of damages upon termination of the agreement may include damages related to competition.
Covenants not to compete with rank-and-file employees are not enforceable in Colorado. This may surprise some, as numerous employees likely have executed covenants not to compete though the employees do not meet the permitted exceptions.
In connection with sale and acquisition of a business, the buyer should generally request that the seller agree not to compete in the same or similar business for a period of time in a specified geographical area. This is one of the permitted exceptions. In most cases, substantial value exists in the base of established customers, reputation, workforce and trade secrets.
This value beyond physical assets of the business is sometimes referred to as “goodwill.” The value of this goodwill is often a significant part of what the seller offers to the buyer, and covenants not to compete help to protect the value of this goodwill.
The three critical components of a covenant are: (1) scope of prohibited business activities; (2) geographical area in which the competition is prohibited; and (3) duration of the covenant.
With respect to scope, restrictions are often limited to activities of the business when purchased, subject to any negotiated modifications. Geographical limits typically cannot be overly broad and are many times limited to the existing geographical area in which the business operates at the time of the sale. Finally, the covenant must be a reasonable length.
A covenant not to compete, supported by consideration, is presumed reasonable. The party challenging enforcement bears the burden of showing the covenant is unreasonable. Colorado law presumes that a party’s breach of a covenant results in an irreparable injury, for which legal remedies are inadequate. The buyer may seek injunctive relief whether or not the buyer proves damages. The proper measure of damages is the purchaser’s loss of profit attributable to the breach. The buyer may later assign a covenant not to compete if the buyer later sells the business to a third party, provided the covenant permits assignment.
On the sale of a business, one of the items negotiated is an allocation of purchase price. Typically, very little is allocated to a covenant not to compete as it results in ordinary income to the seller of the business, but must be deducted over 15 years. Therefore, it is important to provide that damages for violation of the covenant are not limited by the amount of the purchase price allocated to the covenant.
Even though covenants not to compete are generally not enforceable in Colorado, there are exceptions worth utilizing in appropriate cases.
Gerald H. Hansen is an attorney with Stinar & Zendejas LLC, a full-service business and estate planning firm. Find more information at www.coloradolawgroup.com or call 719-635-4200.