The value of a Restraint of Trade in a business acquisition

By Wessel Robertson | Director

The purchase price for an established business often reflects considerably more than its tangible assets. Customer relationships, reputation, supplier networks, market position and the knowledge associated with the business may account for a significant proportion of its value.

For a purchaser, part of the transaction is therefore about ensuring that the value acquired can be retained after implementation. A seller who receives payment for the goodwill of a business and then immediately establishes a competing operation may be well placed to draw on the same relationships, knowledge and market presence that contributed to the price paid by the purchaser.

A restraint of trade can play an important role in addressing that risk. In some acquisitions, a specific portion of the purchase consideration is allocated to the restraint itself. That allocation should not, however, be approached as an arbitrary percentage added to the transaction documents. It raises a broader commercial question about the value being protected and the extent of the restriction reasonably required to protect it.

Protecting the goodwill acquired

The courts have long recognised that restraints associated with the sale of a business stand on a particular footing. In Basson v Chilwan, the Court explained that, in the case of a sale of business, goodwill is an existing asset transferred from seller to purchaser, with its value ordinarily reflected in the purchase price. Competition by the seller may therefore directly affect the value of an asset for which the purchaser has paid.

The Supreme Court of Appeal has similarly recognised that a restraint imposed on a seller may form part of the protection afforded to the goodwill being acquired. The underlying commercial rationale is relatively straightforward. A seller should not be permitted to dispose of goodwill for value and then immediately act in a manner that undermines that goodwill.

The protection is not unlimited. A restraint must still be reasonable and directed at a legitimate commercial interest. Its duration, geographical reach, scope of activities and effect on the seller remain relevant to the enquiry.

A recent Western Cape High Court decision in Citadel Holdings (RF) (Pty) Ltd and Others v Stratfold again highlighted the distinction between an ordinary employment restraint and one connected with the sale of business interests. The Court considered the client relationships and value being acquired, together with the duration and scope of the restraint, in determining whether the protection sought was justified.

The purchaser is therefore entitled to protect the goodwill it has acquired, but not to eliminate competition simply because doing so would be commercially advantageous.

Determining what a restraint is worth

The appropriate value and scope of the restraint depend heavily on the nature of the business.

A founder-led business in which customer relationships are closely associated with the seller may require materially different protection from an established operation where clients identify primarily with the corporate brand. The same applies where a seller has extensive industry relationships, specialist knowledge and the resources necessary to establish a competing enterprise relatively quickly.

The geographical reach of the business is equally relevant. A national business may justify broader protection than one operating predominantly within a particular province or city. Duration also must be considered in the context of the time reasonably required for the purchaser to consolidate the relationships and goodwill being transferred.

The restraint should also correspond with the activities of the business acquired. Preventing a seller from competing directly for the customers and business interests that have been sold is fundamentally different from preventing that person from participating in an industry more broadly.

These considerations become particularly important where the parties intend allocating an identifiable amount of the purchase price to the restraint. The value attributed to it should bear a rational relationship to the commercial risk being addressed and the protection afforded to the purchaser.

Balancing protection with commercial reality

The seller’s ability to continue earning a living remains part of the assessment.

Many transactions involve entrepreneurs who intend remaining active in their industry after the sale. Some may retain interests in other businesses, continue providing services in areas outside the acquired operation or remain involved with the purchaser for a transitional period.

Careful drafting can accommodate those commercial realities without compromising the goodwill being acquired. A restraint may, for example, focus on particular customers, services, products, territories or competing activities rather than attempting to exclude the seller from an entire market.

Where consideration is separately allocated to a restraint, the tax and accounting treatment of that payment should also form part of the transaction planning. The consequences can depend on the nature of the recipient and the structure of the transaction, making it important that the contractual allocation reflects the substance of the arrangement.

A restraint of trade in a business acquisition should ultimately be considered alongside the purchase price, valuation of goodwill, handover arrangements, earn-outs and other mechanisms intended to preserve value after the transaction has closed.

The central issue is the value that could reasonably be placed at risk if the seller were free to compete immediately, and the extent of the protection required to preserve it. Approached in that way, the restraint becomes part of the economics of the transaction rather than a standard provision dealt with once the principal commercial terms have already been agreed.

If you are acquiring or selling a business, the restraint provisions should be considered as part of the commercial structure of the transaction, together with the purchase price, goodwill and post-sale arrangements. The Fairbridges Corporate and Commercial team can assist with structuring and negotiating restraints that protect the value of the business while remaining appropriately tailored to the transaction.