One of the most significant risks facing a business seller is the cost associated with educating a potential purchaser in the event a deal falls through. It is standard practice to require any potential acquirer to execute a non-disclosure agreement, but the breadth of that contract can go a long way to mitigating the seller's risk.
Most buyers will balk at an industry non-compete clause following failed negotiations. Indeed, in most cases, the buyer will already have substantial experience in the seller's business. But often times, a general non-disclosure clause will not be enough to protect the seller. A recent case out of Alabama serves as a compelling example.
In 2006 and 2007, an entrepreneur named Mark Greenshields became interested in purchasing a video-racking division owned by Movie Gallery US, LLC. This business involves placing movie rentals in racks at consumer locations, such as grocery or convenience stores. The deal fell through in May of 2007, and Greenshields started his own video-racking business shortly thereafter. He hired three former Movie Gallery employees within a few months after the transaction imploded, and the new business eventually took about ten former Movie Gallery customers.
It's not at all clear that the defendants' monetary exposure was that great. Movie Gallery itself had been losing money in this business and was trying to jettison the video-racking division to focus on more profitable business segments. However, it sued Greenshields and the entities he formed for breach of the transaction non-disclosure clause.
The court, ruling under Alabama law, found that Movie Gallery failed to prove that the defendants breached any confidentiality obligation. Noting the evidence largely was circumstantial, the court highlighted the following as important flaws in Movie Gallery's theory of breach:
(1) Less than half of the defendants' new customers were ex-Movie Gallery customers;
(2) Ten customers was a relatively small number given that three former employees were working full-time in the business;
(3) No profitability analysis was ever conducted on the lost customers, suggesting that there was no evidence defendants targeted profitable, quick-paying accounts;
(4) The supply sources were known by the new employees given their long history in the business;
(5) The customer lease agreements were drafted by defendants' counsel, and the terms were generally known in the business and ascertainable simply by asking the customers themselves.
The court was unable to make the leap in logic demanded by Movie Gallery: that Greenshields had to be using information disclosed to him during due diligence of the failed transaction. The following summarizes succinctly the quandary faced by the court, which suggests it believed Movie Gallery should have required Greenshields to sign a more extensive non-disclosure agreement:
"The fact that Greenshields may have, through viewing confidential information over the course of several months, become more familiar with the specific accounting and business principles involved in a racking operation surely is not the equivalent of his using specific pieces of confidential information....[The non-disclosure] agreement specifically contemplated that Greenshields may compete, and it is only logical that Movie Gallery could not expect him to rid his mind of general knowledge acquired through his months of studying an industry new to him."
At a bare minimum, a seller of a business ought to require a buyer not to hire or engage a seller's employees for a period of time. In a case like Greenshields', his lack of experience in the business was not a deterrent to opening a competitor rather quickly; he took three long-time employees away from Movie Gallery to do the leg work.
Additionally, sellers need to consider limited customer non-solicitation covenants requiring a purchaser to avoid certain accounts following the termination of a potential deal. Sellers also can line-out customer names until the transaction negotiations reach a certain point, but in many cases this is neither feasible nor acceptable.
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Court: United States District Court for the Middle District of Alabama
Opinion Date: 9/1/09
Cite: Movie Gallery US, LLC v. Greenshields, 648 F. Supp. 2d 1252 (M.D. Ala. 2009)
Favors: N/A
Law: Alabama
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