Looking Past The Headlines, The Impact Of The FTC's Ban On Non-Competes In M&A, Private Equity And Venture Capital

Last week on April 23, 2024, the FTC adopted a final rule that would effectively ban non-compete agreements in the context of employment relationships when the rule becomes effective on September 4, 2024, absent a stay or injunctive relief. The rule would render unenforceable a broad array of employment-based non-competition agreements. It would also require that employers provide notice to workers that certain non-competition agreements already entered into will not be and cannot be enforced. Not surprisingly, before the weekend, at least three different lawsuits had been initiated challenging the validity of the FTC's final rule as adopted. For firms engaged in M&A activity, investors and their advisors, they should carefully track whether the rule is struck down as it may impact standard buyer protection strategies with key employees of the target.

What the Rule Says

The core of the rule is found in 16 CFR 910.2(a), which states that it is an unfair method of competition under the Federal Trade Commission Act for an employer to enter into, attempt to enter into, enforce or attempt to enforce a non-compete clause against a worker. The term "worker" is defined as a natural person who works for the employer and the term expressly includes independent contractors. The term "non-compete clause" is defined very broadly as a term or condition of employment that prohibits a worker from, penalizes a worker for, or functions to prevent a worker from, seeking or accepting employment after conclusion of employment or from operating a business in the United States after conclusion of employment. Workers defined as "senior executives" are treated differently: while it is still an unfair method of competition to enter into a non-competition agreement with a senior executive after the effective date of the rule, employers are permitted to enforce non-compete clauses entered into with a senior executive before the effective date of the rule.

Limited Impact in M&A

As a general matter, the FTC's final rule does not apply to non-compete arrangements entered into by a person pursuant to a bona fide sale of a business entity, sale of the person's ownership interest in the business entity or sale of all or substantially all the assets of a business entity's operating assets. 16 C.F.R. § 910.3(a). The language of the rule is unclear whether "sale of a business entity" requires sale of 100% of the interests in the business entity or whether a smaller stake, perhaps a mere majority interest, is sufficient to qualify as a "sale of a business entity". Despite this ambiguity, firms engaged in M&A activity can expect that non-compete clauses will continue to be enforceable against sellers of business entities, at least, in the regular course, which among other things allows for allocation of purchase price to the non-compete for tax purposes. Seasoned corporate practitioners may raise an eyebrow to the use of the term "bona fide" in describing the exemption from the rule. Ostensibly the FTC seeks to limit employers from engaging in a "sham transaction" of a business interest to secure the benefit of the exemption in the proposed rule Buyers of businesses will need to undertake due diligence around the enforceability of non-compete clauses purporting to bind key employees of the target company; some of those non-compete clauses may have been rendered unenforceable and constitute violations of the new rule. .

Major Impact in Capital Markets

While the FTC's final rule may be of modest impact to those engaged in M&A work, those engaged in deploying growth capital will have a more complicated road ahead in connection with the FTC's new rule. There is no exemption for non-compete clauses entered into as a condition for investing capital into early stage and growth companies. While sales of businesses are priced on established multiples or other well-understood pricing mechanisms, venture capital investors, private equity investors deploying growth equity, and other capital providers often find themselves betting on a prospective portfolio company's management team to execute on business plans and pro forma projections. Accordingly, the human capital risk is heightened, and in the absence of a secondary liquidation of equity interests of the management team, investors who usually condition their capital on the management team members entering into non-compete arrangements will find that this tool is no longer available to them when it comes time to protect their investment

A Reprieve for Non-Competes with Senior Executives

In a change from the FTC's initial proposed rule, the final rule does not impact existing non-compete arrangements with "senior executives" who meet certain duty and remuneration thresholds, but this is not a solution for prospective non-compete arrangements with senior executives after the effective date. 16 C.F.R. § 910.1.

Near Term Mitigations

While venture capital and private equity investors will invariably be waiting to see how the litigation filed immediately on the heels of the FTC's announcement shakes out, it is perhaps more important than ever to begin considering whether transaction terms protect capital providers.

1. A common-place exercise in the venture capital world, asking members of an operating team to "re-vest" their equity, will likely creep upmarket as a regular term in any investment transaction that does not include a liquidation of existing ownership interests.
2. In later-stage transactions wherein capital providers are providing capital in tranches, we will likely begin to see more covenants regarding the operating team continuing their employment with the issuer at the time of each tranche of capital is disbursed, more akin to private credit arrangements.
3. The FTC rule incentivizes the use of confidentiality clauses and trade secrets protection language to limit unfair competition by departing members of the management team and may result in an uptick litigation for such breaches, but less certainty compared to non-compete enforcement.

A Need for Vigilance and New Thinking

Broader in title than it is in fact, the FTC's final rule on non-competes certainly gives rise to concern for those engaged in corporate transactional matters and more for those involved in emerging growth and middle-market capital formation. For capital providers the specter of allocating capital to an issuer or borrower who subsequently loses some or all its differentiating operating team is real.

Perhaps more than ever before, financial incentives for retention, perfection of intellectual property rights, and culture must be revisited and enhanced.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.