But I Didn’t Sell All of It: Noncompetition Agreements in Connection with the Partial Sale of a Business

California law takes a restrictive view on noncompetition agreements. The default position is that they are prohibited unless statutory exceptions to the general prohibition apply. One such longstanding exception is when one sells his or her entire ownership interest in a business, the so-called “sale of ownership interest” exception. But, it had been somewhat of an open question as to whether an owner’s sale of only part of their ownership interest permitted imposition of a noncompetition agreement on the seller.

Recently, the California Court of Appeal in Samuelian v. Life Generations Healthcare, LLC, 104 Cal. App. 5th 331 (2024) answered that question in the positive, holding that one who sells less than his or her entire ownership interest in a business entity may be subject to a noncompetition agreement. The court further held the validity of the noncompetition agreement should be analyzed under a different standard—the reasonableness standard—historically most often used in commercial disputes between businesses involving antitrust allegations. Notably, the California Supreme Court recently declined to review the Samuelian decision. (Petition for review denied (Case No. S287122) November 13, 2024.)

Background

Robert and Stephen Samuelian (the Samuelians) co-founded Life Generations Healthcare, LLC (the Company) with a third individual. The Samuelians initially owned nearly half of the Company, but they later sold a portion of their interest. As part of that sale, the Company adopted a new operating agreement that included a noncompetition provision. The noncompetition provision prohibited the Company’s owners from competing with the Company in California.

Later on, the Company allegedly discovered the Samuelians had breached the noncompetition provision—which the Samuelians denied—but they were frozen out of the Company.

In arbitration and later in court, the Samuelians and the Company disputed whether the noncompetition provision was valid. The Samuelians argued the provision was per se invalid under Business and Professions Code section 16600 because they had not sold their entire ownership interest in the Company. The Company argued that the court should apply a different standard, the reasonableness standard, most often applied to analysis of noncompetition provisions in commercial contracts between two businesses.

Court of Appeal’s Holding

The court began with a discussion of Business and Professions Code section 16600 and the per se and reasonableness standards. Section 16600 prohibits any contract that restrains a person from engaging in a lawful profession, trade, or business—which includes noncompetition agreements. Despite its broad language, section 16600 provides for noncompetition agreements to be evaluated under two standards: (1) the per se standard; and (2) the reasonableness standard. The per se standard holds that noncompetition agreements are per se invalid without consideration of their reasonableness. The reasonableness standard looks at whether a noncompetition agreement harms competition more than it helps competition.

In determining which standard to apply, the court analogized to a very different context, that of employer and employee (not, as in Samuelian, a business transaction context). Specifically, the court analogized the sale of an entire versus partial ownership interest to a terminated versus current employee. The court found that owners who sell only part of their ownership interest remain owners of the company, may keep a significant connection to the company, and owe a fiduciary duty of loyalty to the company, which prohibits the owner from competing. The court also noted that in the sale of a partial ownership interest, noncompetition agreements could benefit competition, such as by ensuring the selling owners are invested in improving the company.

The court found applying a per se standard where the seller retains an ownership interest and may owe a fiduciary duty to the company would interfere with that fiduciary duty.

On these bases, the court held the reasonableness standard applied to the noncompetition provision.

Takeaways

• Samuelian opens the possibility for a noncompetition agreement when an owner is selling only part of their ownership interest.
• In order to potentially withstand judicial scrutiny, noncompetition agreements in connection with partial ownership sales need to satisfy the reasonableness standard—to be more helpful to competition than harmful.
• Both sellers and purchasers of partial interests in a business should carefully consider whether a noncompetition agreement is possible under the circumstances of a particular transaction, including the number of persons selling their interests, the percentage ownership interest sold, the position within the selling company held by the person selling his or her interest, and whether under the circumstances the reasonableness standard should be applied at all, and if yes, how these facts may impact the question of whether imposition of a noncompetition agreement is helpful to competition.

Companies wishing to adopt a noncompetition agreement in connection with a partial ownership sale should carefully consult with counsel.