By: John M. Stinar, Esq.
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.
(originally published in the March 2013 eNewsletter)
John M. Stinar is a partner with Stinar & Zendejas, LLC, a Colorado Springs law firm that represents individuals and companies in a wide range of legal arenas, including business formation and planning, tax matters, estate planning, real estate, Regulation D offerings, domestic asset protection, employment law, non-profit representation, probate, estate administration, civil litigation, and probate litigation. Stinar and Zendejas attorneys are licensed to practice law in the State of Colorado. John’s practice includes taxation, estate planning, asset protection, entity formation, real estate transactions, general business matters, and representation before the Internal Revenue Service and United States Tax Court. John is also a Certified Public Accountant by background. You may contact John at (719) 635-4200.