Become a Financial Modeling & Valuation Analyst (FMVA)®. Enroll today to advance your career!
Login to your new FMVA dashboard today!

Restrictive Covenant

A provision in an agreement that prevents one party from taking a taking a specific action

What is a Restrictive Covenant?

A restrictive covenant is a promise included in a legal agreement, and it prevents one party in the contract from taking a taking a specific action. When a party enters into a restrictive covenant, he/she agrees to refrain from doing something on the property or using it in a certain way that is restricted in the contract.

 

Restrictive Covenant

 

For example, when purchasing real estate, the buyer agrees to use the property for the designated purpose only and not for other purposes. If the agreement specifies that the property can only be used for residential purposes only, the buyer cannot convert the property for business use.

 

Types of Restrictive Covenants

The following are the different types of restrictive covenants:

 

1. Non-complete agreement

A non-compete agreement restricts one party from competing directly with the other party for a specific period of time or within a defined geographical location. The party that agrees not to compete must be compensated by the other party, and it is an additional cost to the business.

For example, an employer may require employees to sign a non-compete agreement, which prevents them from competing with their employer when they leave the company. Another example of a non-compete agreement is when business owners dispose of their businesses, and they agree not to compete with the new owner for a certain period of time.

 

2. Non-solicitation agreement

A non-solicitation agreement restricts one party from soliciting employees and customers from the former employer after leaving the business. Many businesses require their senior executives like managers, accountants, and CEOs to sign a non-solicitation agreement, which can be in the form of a single document or a clause in an existing document.

To be enforceable, the employer/business must define reasonable limits, either according to a period, geographical area, or type of work. In some states such as California, there are specific laws that make non-solicitation agreements unenforceable unless they are introduced to protect trade secrets.

 

3. Non-disclosure agreement

A non-disclosure agreement is a legal contract between an employer and employee, which prevents the latter from disclosing proprietary and confidential company information and processes. In return, the employee must be properly compensated for signing the non-disclosure agreement.

The agreement is active during the employee’s tenure and for a specific period after exiting the company. For the contract to be enforceable, the agreement must be protecting valuable information such as a trade secret or confidential information about the business.

 

Restrictive Covenants in Real Estate

Restrictive covenants in real estate exist to prohibit the use of a property in a certain way by its occupants. Such restrictions exist in limited-access communities and condominiums that are built in a similar design, and the developers intend to preserve the style of the property.

Some of the restrictions that may be introduced on a property may include prohibiting owners from carrying out business activities on the residential property, running a home-based business, or installing a home office on the premises.

The restrictions on real estate may also be in the form of architectural guidelines. The seller of the property may limit any renovation plans that may alter the original appearance of the property. The seller’s intention is to maintain the color scheme and design of properties in the neighborhood, since altering the guidelines may lower the value of the property.

Even when a purchaser decides to sell the property to another buyer, the restrictions are passed to the subsequent owners. Any violations of the property guidelines will result in lawsuits and fines.

 

Restrictive Covenant in Employment Contracts

Restrictive covenants are introduced by employers to prevent employees from taking certain actions in the course of the employment and for a defined period after the employee’s departure from the company. The most common restrictive covenants are non-compete and non-disclosure agreements. Since the management’s invested a lot of money into company activities, employees, and customers, the covenants are designed to preserve such investments.

 

Limiting Restrictive Covenant Agreements

Whether the restrictive covenants will be enforceable or not depends on the current laws at the state levels. Some states impose varying rules on what clauses in the restrictive covenant agreements are allowed and the terms that cannot be upheld in the courts.

For example, non-compete agreements are unenforceable in California, even if the employee signed the contract voluntarily and was compensated for entering into the agreement. Courts mostly side with the employees, especially when they find the terms of the agreement to be unfair or exceed the level of protection granted to employers.

 

Additional Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Golden Parachute
  • How to Quit a Job?
  • Reasons for Leaving
  • Severance Pay

M&A Modeling Course

Learn how to model mergers and acquisitions in CFI’s M&A Modeling Course!

Build an M&A model from scratch the easy way with step-by-step instruction.

This course will teach you how to model synergies, accretion/dilution, pro forma metrics and a complete M&A model. View the course now!