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Business Law

Are Non-Compete Provisions Permissible among Limited Liability Company Members?

Generally, non-competes are not enforceable in California as set forth in California Business and Professions Code section 16600 which states that, “[e]xcept as provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” There are some limited exceptions to this rule. One of those exceptions is when an owner of a business sells the company’s goodwill or interests. Business and Professions Code section 16601 provides in part that “any person who sells the goodwill of a business, or any owner of a business entity selling or otherwise disposing of all of his or her ownership interest in the business entity” may agree with the buyer to refrain from carrying on a similar business within a specified geographic area. The provision presents three important factors that should be carefully considered and clearly defined: the business entity, its goodwill and its impact within a specified geographic location.

The term “business entity” is defined in section 16601 to mean a partnership, limited liability company, or corporation. Further, Business and Professions Code section 16602.5, permits a member of a limited liability company to agree not to compete “upon or in anticipation of a dissolution of, or the termination of his or her interest in” the limited liability company. Thus, an operating agreement can and should specifically and carefully define the non-compete parameters in the instance a member decides to sell his goodwill of the business. Furthermore, the drafting of an operating agreement with a non-compete clause should fairly consider the fair market value of the goodwill. A limited liability company’s operating agreement which includes provisions for departing members to sell their interests back to the company for an amount less than fair market value — without including goodwill – that yet still impose a covenant not to compete, are likely not to fare well in court.

Finally, the operating agreement should specify a reasonable geographic location. Such consideration will be dependent on the type of business and market reach of the company and the future business prospects of the departing member.

Although, difficult to contemplate at the formation of a company, non-competes should be included in an operating agreement to avoid potential litigation should any member terminate his interest in the company and attempt to compete with the former company.

This eBulletin was prepared by Carmen M. Aviles at Hopkins & Carley (caviles@hopkinscarley.com).

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