With certain exceptions, Colorado law prohibits the enforcement of covenants not to compete.  The assumption is that the State of Colorado wishes to have its citizens engaged in gainful employment.

Specifically, Colorado Revised Statute § 8-2-113 provides that “it shall be unlawful to use force, threats or other means of intimidation to prevent any person from engaging in any lawful occupation at any place he sees fit.”  The Statute further goes on to provide that 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 shall be void except for the following: (1) any contract with the purchase and sale of a business or the assets of a business; (2) any contract for the protection of trade secrets; (3) any contractual provision providing for recovery of the expense of educating and training of an employee who served as an employer for a period less than two years; and (4) executive and management personnel officers and employees who constitute professional staff to executive and management personnel.  The Statute provides for a fifth exception related to the practice of medicine.  Specifically, while a physician cannot be prohibited from practicing medicine, he or she may be liable to a previous practice for damages caused by his/her termination of their previous employment including, but not limited to damages related to competition.

The focus of this article is on covenants not to compete in the context of a sale of a business.  In the vast majority of transactions involving the sale and acquisition of a business, the buyer should always bargain for a covenant given by the seller of the business not to compete in the same or similar business for a period of time in an agreed upon geographical area.  In most cases, substantial value exists in the business’ base of established customers, reputation, routines and trade secrets.  This value beyond the physical assets of the business is sometimes referred to as “goodwill.”  The value of this “goodwill” is a significant part of what the seller offers to the buyer and covenants not to compete protect the value of such “goodwill.”

The three critical components of a covenant are as noted above, the scope of the prohibited business activities, the geographical limitation of the covenant and the length of time of the covenant.  With respect to the scope of the covenant, the restrictions are typically limited to the definition of the activities of the business when purchased, subject to any negotiated modifications.  The geographical limits to the covenant typically cannot be overly broad and are usually limited to the existing geographical foot print of the business at the time of the sale of the business.  Again, that can be modified by agreement to some degree.  Finally, the covenant must be a reasonable length.  Typically five years is standard.  Although in the sale of a business context, Colorado courts have found reasonable covenants not to compete for three years in a twenty-mile radius, for five years throughout a designated area; for five years in a single county; for five years in a fifty-mile radius; and, for ten years throughout Colorado. 

A covenant not to compete, supported by consideration, is presumed reasonable.  The party challenging enforcement of the covenant bears the burden of showing that 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 is entitled to injunctive relief and such relief is appropriate 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 of a business may later assign a covenant not to compete if he/she later sells the business to a third party, if the covenant permits assignment.  The covenant will pass to a new buyer and the new buyer may enforce the covenant. 

Finally, on the sale of a business, one of the items negotiated is an allocation of purchase price.  It is typical that very little of the purchase price is allocated to a covenant not to compete as it results in ordinary income to the seller of the business but retains the same fifteen year amortization that is otherwise assigned to the goodwill of the business outside the value of the covenant not to compete.  Therefore, it is important in drafting the actual agreement outlining the covenant not to compete, to provide that damages are not limited by the amount of the purchase price allocated to the covenant, in the event of a violation of the covenant. 

Again, even though covenants not to compete are not favored in Colorado, covenants related to the sale of a business are generally enforceable in Colorado. 

– John M. Stinar, Esq.

We live in a litigious society. We see news stories about the latest lawsuit, and how a jury awarded a zillion dollars for something that appears minor. (Paging, the McDonald’s My coffee is too hot award.) There are also social networking sites dedicated to spreading the word about frivolous law suits. (https://www.facebook.com/ColoradoLawsuitAbuseWatch?) Countless clients, after a suit is over shake their heads wondering why they had to go through it. While risk cannot be eliminated, there are a number of steps that should be taken to try to minimize a businesses’ personal liability.

First, what kind of business are you in, and does the use of an entity (a corporation, a limited liability company, a limited partnership, etc) decrease your exposure? Generally an individual is not responsible for corporate (or other entity) debts or liabilities. But be careful: you are always responsible for your own actions. A quick example is seen in the construction industry. There, the builder (definitions vary) still owes his client a duty to build in a workman like manner, in spite of the fact the he has formed an entity to attempt to minimize liability. Forming an entity may allow you to take the first step to minimizing personal liability and keeping any debt and exposure at the entity level. Also, beware of forming the entity, by yourself. These are typically fine, if there are no other owners, but the agreements in the entities establish each of the owner’s rights, duties and liabilities among them. This is why caution should be taken before resorting to online forms.

Second, get the appropriate insurance, and the right amount of insurance. Learn what kind of insurances are available, and equally important, learn what the real expectations you should have from those policies. It is also important to know what kinds of policies exist for your business. You should have this discussion with your insurance broker, others in your business, and even your attorney. Remember, however that with every policy, there are exclusions, limitations, and exceptions.

Third, before signing any document, read it, understand it, and if it is something you are not familiar with, determine whether you should seek to have it reviewed. Countless clients ask for clarification about what a contract means after signing. Leases, promissory notes, personal guarantees, purchase orders, sales contracts, for example, can be difficult to understand, especially the first time that you are presented with one. Take the time to review the document, and understand what it means. Are there terms of art? Was it drafted to that is a fair document, or is it boiler plate? What obligations are you signing up for? Can terms be negotiated that help you or offer protection?

Fourth, do not be afraid to ask for advice. I recall a client coming to me after firing an employee, and asking what he should do about an employee issue. He had failed to have an employment agreement, an employee manual, and had failed to document the employee’s continued transgressions. Unfortunately, this employee had sued a prior employer, and knew the system. My client was ultimately successful, but this was after the matter went to trial. Advice on how to discipline an employee, and to document employee’s tardiness, etc would have made the dispute much easier to defend, or could even have prevented the ex-employee from bringing suit. You may also be surprised at how friendly your competitors are if you approach them, and ask for advice. There are several trade organizations where business owners often more than happy to help one another out.

Fifth, if you are going into business with a partner, put your agreement in writing. Spend the time to negotiate the deal points. Any attorney will tell you that putting together a company is much easier, than seeing one come apart. In the beginning, most agreements are amicable, as everyone seems to want to complete the deal. When there is a dispute among owners, then you will have to live up to what you agreed to. What is the buy out process? What rights does a minority owner have? What can the majority owner do without the consent of all of the other owners? These are all issues that should be agreed to ahead of time and reduced to writing.

While it is not possible to eliminate the risk of running a business, there are steps to minimize it. Determine whether your business will benefit by using an entity. Talk with someone with experience about your insurance needs. Read, understand and turn to others to help you with the meaning of documents before you sign them. Talk with others when dealing with new situations. By following these steps, you may be able to avoid being the next headline or being in front of a jury of your peers.