California: It All Comes Down to Goodwill.
Generally speaking, non-competes are void under California law.[1] Exceptions do exist. In the context of the sale of goodwill in a business, for example, the seller may agree not to compete with the buyer so long as the buyer carries on a like business.[2] This makes sense because it would be unfair for the seller to engage in a competitive business that diminishes the value of the business sold. So how does this work in practice?
In Hill Medical Corporation v. Wycoff,[3] the court had to decide whether a non-compete between a radiology practice (“Hill”) and a doctor (“Wycoff”) was enforceable under California law. Under the employment agreement and stock redemption agreement between Hill and Wycoff, in the event of a buyout, Wycoff was required to sell his stock back to Hill and to refrain from competing within a 7.5-mile radius for three years. In 1998, Wycoff resigned from Hill and sold his shares back to Hill for a repurchase value that did not include any component of goodwill. Subsequently, Wycoff tried to practice radiology within the same area. Hill filed a lawsuit to enforce the covenant not to compete. The trial court held that the non-compete clause was unenforceable and did not fall within the exception because the stock repurchase price did not include anything one might consider goodwill.
On appeal, the court explained that California settled public policy in favor of open competition. Thus, any agreement not to compete that restrains anyone from engaging in a lawful profession, trade, or business of any kind is void under California law, regardless of its reasonableness, unless it involves the sale of goodwill. For this exception to work, however, the court said that there must be a clear indication that the parties valued or considered goodwill as a component of the sale price. When the sale involves a fractional interest in a corporation, as here, it must be a substantial interest so that the owner, in transferring “all” of his or her shares, can be said to transfer the goodwill of the corporation; simply selling shares to the corporation does not necessarily demonstrate that goodwill is part of the agreement, though such intent can be shown indirectly, such as when fair market value is paid for the shares. Here, the court found that the repurchase price was not fair market value, as the appropriate valuation for a similar business for Wycoff’s fractional share would have been a sum far exceeding the amount he received. Moreover, the repurchase price did not show that Wycoff significantly benefited from an appreciation in the value of the stock over the two decades he held the shares. In other words, there was no suggestion that goodwill was considered at all in arriving at the repurchase value. And because there was no compensation for goodwill, the court held that the non-compete covenant between Hill and Wycoff was void and unenforceable.
This post was part of a multi-part series on covenant not to compete in the context of buying or selling a business. You can find the other posts by searching our blogs at www.mcbrideattorneys.com. In our next post, we will discuss non-competes under Florida law.
This posting is intended to be a planning tool to familiarize readers with some of the high-level issues discussed herein. This is not meant to be a comprehensive discussion and additional details should be discussed with your transaction planners including attorneys, accountants, consultants, bankers and other business planners who can provide advice for your circumstances. This article should not be treated as legal advice to any person or entity.
Steps have been taken to verify the contents of this article prior to publication. However, readers should not, and may not, rely on this article. Please consult with counsel to verify all contents and do not rely solely on this article in planning your legal transactions.
[1] See Cal. Bus. & Prof. Code § 16600.
[2] Id. § 16601.
[3] See generally Hill Med. Corp. v. Wycoff, No. B134869 (Cal. Ct. App. Jan. 30, 2001). Unless otherwise noted, all references to the case are from this citation.