February 20, 2023

The Impact of the FTC’s Proposed Non-Compete Rule on M&A

The Federal Trade Commission (FTC) recently proposed a series of sweeping changes to current non-compete law that would effectively ban these agreements between employees and employers under most circumstances. If implemented in its current form, the rule would substantially change how employers and acquirers utilize restrictive covenants, with potential impacts across compensation structures, M&A dynamics, and valuations.

Today, non-competes are primarily utilized within M&A to protect company information, trade secrets, and competitive advantage following a transaction. Digging deeper, they are an effective tool to keep valuable executives and employees from jumping ship or launching a well-capitalized competitor. Typically, these agreements are established for durations ranging from six months to five years following closing, though the current enforceability of non-competes varies widely depending on the state within which they are signed. Non-competes are usually required of all shareholders actively involved in the business and other “key” employees defined by the acquirer during the diligence process.

The proposed FTC rule defines non-compete clauses in an unprecedentedly broad manner to include any contractual term between an employer and a worker “that prevents the worker from seeking or accepting employment with a person, or operating a business, after the conclusion of the worker’s employment with the employer.” The rule does not appear to distinguish between employees with key skillsets, type of employee (independent contractor, full-time, intern, etc.), or level of employee access to competitively sensitive information. The proposed rule would also apply to all types of workers, including independent contractors, interns, and volunteers who provide service to a client. Further, the FTC indicates that, while other types of agreements (customer non-solicitation agreements, confidentiality agreements, etc.) are not expressly prohibited, such agreements may be considered “de facto” non-competes if they have the same practical effect.

The proposed rule does have a limited exception for sales of businesses, stating that a non-compete is only enforceable against owners of at least 25% of the business at the time they enter into the non-compete clause. Thus, a founder who is heavily involved in day-to-day operations, but has been diluted to below 25% ownership, would not be bound to a non-compete in a sale of the business.

Additionally, the proposed rule would require employers to rescind any non-competes agreed upon before the rule’s effective date by providing notice to any workers already subject to non-compete restrictions. This will likely complicate M&A diligence efforts and add a regulatory burden as acquirers will need to assess the number and breadth of any non-competes and whether the business has properly rescinded them prior to the acquisition. If they have not, both parties will likely be vulnerable to additional legal liability, and structures will need to be created to mitigate this risk.

From a seller’s perspective, the potential implementation of these changes could be favorable to individuals who own less than 25% of the outstanding equity in a transaction. They would no longer be restricted from pursuing competitive endeavors post-close, and shareholders who owned 25% or more would experience a status quo situation post-close. However, as buyers assess the merits of a transaction, greater risk around employee and leadership retention is likely to impact value, if not structure. Will multiples for these businesses, especially those deeply embedded in the Knowledge Economy, compress as buyers fail to ensure talent retention?

Sellers may look to mitigate this potential risk by distributing equity more broadly amongst management teams or working with buyers to design more attractive retention plans. While asking founders to distribute significant equity ownership may seem dilutive, if a sufficient economic premium is generated in the eyes of a potential acquirer, then it may end up being accretive in the long run. Founders may also instead look to shift a portion of deal proceeds toward retention bonuses and plans for key employees. This serves the double purpose of rewarding employees critical to a company’s success and retaining them for future growth. Although this typically has adverse tax consequences for these employees when compared to the capital gains of traditional equity ownership, we see this strategy deployed often.

As the FTC considers these rule changes, several alternative arrangements may be discussed. Rather than the 25% or more of ownership exemption from the ban, the FTC may pivot to a dollar threshold to address concerns around large payouts that could help launch a competitive firm. The issue with utilizing a 25% threshold is ensuring appropriate precautions are taken to make the non-compete effective. If a partner owns 15% of a $10M business, their transaction proceeds are a nice payout but not enough to launch a competitor. But if someone owns 15% of a $500M business, their proceeds are certainly large enough to consider launching a competitive firm (especially in a non-capital intensive industry).

The FTC may also consider an exemption for trade secrets by restricting employees who possess critical business knowledge on the basis they could disclose this knowledge to competitors. Along the same lines, there could be additional distinctions between classes of employees, with different standards established for hourly vs. salaried workers, for example. Finally, the FTC may look at a blanket senior management exemption. Though a senior team member may not possess meaningful equity ownership in the enterprise, they may still be essential to the business in other ways and could cause serious detriment if they left to join a competitor. The FTC has asked for public comment on these and several other ideas and will likely incorporate some modifications from the current plan.

As the FTC’s proposal remains in very early stages, we find it unlikely it will be implemented in its current form. The severity and reach of any changes could have a large effect on the M&A market, particularly impacting deal structures and valuations.

While one may think the FTC’s proposal could cause a slowdown in dealmaking (due to perceived increase in buyer risk), we believe there are sufficient alternative methods of structuring deals to mitigate these concerns. Owners and advisors can prepare before and during a process to ensure premium valuations are maintained while still complying with implemented rules. Please contact us if you wish to discuss more on the FTC’s proposed changes and its impact on exit planning or M&A strategy.