Does Your Due Diligence Have a Blind Spot?

If you are making an investment in a middle market company, a substantial part of the enterprise value may rest in client relationships that are managed by just a handful of mid-level executives. When effective control of the company’s customer goodwill is concentrated in a few key employees, your investment and your exit strategy may be at risk. A relationship manager who defects to a competitor could quickly undermine the company’s revenue projections. Even if the company succeeds in preserving the client relationship, the company may face a period of uncertainty and loss of focus as management shifts into a crisis management mode, and the departure may be an invitation for the client to demand price reductions or for other key managers to demand enhanced compensation as the price of loyalty.

Assessing this risk, the adequacy of the company’s current safeguards, and the opportunity for enhancing the company’s protections must be a part of your deal team’s due diligence checklist. Unfortunately, however, too many investors leave this task solely in the hands of their M&A counsel, who may lack the experience to see the problems and recommend solutions. To ensure your investment is adequately protected, you should insist upon including a seasoned specialist in noncompete litigation as part of your due diligence team.

Most corporate lawyers who handle middle market private company acquisitions will have in their set of form agreements a noncompete that was drafted to bind senior executives holding substantial equity in a Delaware corporation. Although there are potential pitfalls even in this context, most courts recognize both the fairness and the necessity of enforcing reasonable noncompete agreements against selling shareholders who participate in the company’s management, simply to ensure that the investor can protect the value of the business it has acquired. So long as the court views the noncompete as a deal term between buyer and seller, and not as an employment agreement, your M&A counsel are probably on relatively safe ground using their Delaware form noncompete, at least as a starting point.

That critical distinction between a noncompete with a selling shareholder and a noncompete with an employee is where your M&A counsel’s experience may create a blind spot in your due diligence. M&A counsel often assume that any equity participation by an employee is sufficient to transform that employee into a “seller” of the company whose noncompete agreement will be enforced as part of the corporate transaction. Although there is no bright line, courts are alert to the risk of elevating form over substance. Token participation in a stock incentive plan is not a magic wand that will insulate the noncompete agreement from strict judicial scrutiny. For a typical middle market company, it may be difficult to persuade a court to view a noncompete agreement as anything other than an ordinary course employment agreement, once you leave the company’s C-suite.

Employee noncompete agreements are difficult to enforce for a very good reason; they are restraints on competition between parties of unequal bargaining power that are susceptible to abuse. An enforceable agreement requires careful drafting to tailor the agreement’s covenants to the company’s actual business operations and the employee’s role within the company. Careful consideration must be given to variations in state law for companies with offices and employees in multiple states, and the company’s employee handbooks, policies, and procedures must be reviewed to ensure that they are consistent with the restraints imposed by the noncompete’s covenants. This expertise requires counsel with extensive experience drafting and enforcing noncompete agreements in multiple jurisdictions.

So what can you do to avoid this blind spot in your due diligence?  First, you should be proactive to identify the true client relationship managers. Find out who they are, and make sure that your due diligence team is alerted to their strategic significance for the deal.

Next, when it appears that middle management defections are a strategic risk for the target company, you should insist that the attorneys on your deal team include counsel with extensive noncompete experience. Not all employment lawyers are created equal; when the enforceability of a key manager’s noncompete is a material risk for the investment, you need the advice of an attorney who regularly litigates these disputes.

Finally, you should take full advantage of the opportunity the transaction affords to enhance the company’s protections.  During a company’s normal operations, management may treat these “HR issues” as low priority housekeeping items. Due diligence is the perfect opportunity to analyze these issues and develop an action plan for enhancing the company’s noncompetes that can be implemented as part of the transaction.

Sometimes the key employees are the relationship managers whom you may never even meet.  Make sure that when you make an investment, all of company’s key assets are protected. 

Matthew  Prewitt is a partner at Schiff Hardin and co-chair of the firm’s trade secrets and non-compete litigation client services team. He can be reached at mprewitt@schiffhardin.com.