Many employment contracts contain non-compete clauses, which prevent an employee from leaving the company and either moving to a competitor or setting up themselves. The argument including these types of clauses is that an employee is likely to acquire significant knowledge about the company’s business plans and intellectual property (IP) during the course of his or her employment, that the business would not want a competitor to find out.
The protection of business secrets is a reasonable aim, but non-competition clauses are often difficult for employers to enforce because they can restrict too broadly the departing employee’s rights to employment elsewhere.
A lack of enforceability within employment contracts doesn’t help small companies when founders, who are often the best informed people in the business about secrets, fall out. Simply put, it isn’t easy to stop an executive director from setting up on his own just by including a non-compete clause in his service agreement.
A stronger alternative is to place such terms in the shareholders agreement instead – binding founders not as employees, but as owners. These types of terms in agreements are never infallible, but are generally better supported by courts.
A non-compete clause protects all the shareholders by preventing any other from starting a rival business or contributing to a direct competitor. One of the advantages is that it should not only bind departing shareholders, but also current ones, whether they are directors, non-executive directors, other employees or not employed.
One of these clauses also binds shareholders equally regardless of the size of the shareholding. Founders could be just as protected when bringing in a new manager who is rewarded with a small equity stake as well as pay, as when a significant owner sells out because he disagrees with the strategic direction.
Just as for employment contracts, the enforceability of such clauses in shareholder agreements depends on whether the terms are reasonable – something that only a judge can decide.
However, you can increase the likelihood that your clause would be seen as reasonable by limiting restrictions on competing in terms of time, role, geographical area and type of business.
For example, it is probably less reasonable to prevent a shareholder of a UK-based gaming app design company from being involved in a business in the European software industry for 10 years, but is more reasonable that he should wait six months before becoming involved in a gaming company that sells software in the UK. A reasonable scope of restrictions obviously depends on the type of business, but it should look to protect the business, not punish the shareholder. It should be as specific as possible.
You should also bear in mind whether other terms control when a shareholder can compete. If a shareholder is blocked from selling his shares in some way, he is effectively blocked from starting a new competing venture. A short time limitation that on the face of it looks reasonable may never be able to start, and therefore might actually be a potentially unreasonable limitation and an unfair restraint of trade.
Some shareholders try to make any restriction “more reasonable” by including an express acknowledgement by all that the clause is reasonable. Certainly a court will take this into account in a judgment, but it won’t prevent a court from ruling that the term is not enforceable.
Another consideration is that if you bring professional investors into the business (such as business angels or a venture capital firm), one of the factors for making an investment in your company might be prior investment experience in your industry. You should, therefore, not expect these types of investors to want to include clauses that prohibit their current or future investment in similar businesses. Instead, you should look to protect your IP in different ways.
One way of doing this is to limit (using the shareholders agreement) what types of information certain shareholders are told about. You can do this using terms that set out “information rights”. Another way is to set out clearly what types of matters shareholders vote on, as opposed to what types of matter executive directors vote on. Professional investors typically do not take executive board positions, so might be better insulated from the detail of certain operational matters.
Should you include one a non-compete clause in your shareholders’ agreement? We would recommend that you do (a good template should address competition), but that you seek to make it reasonable. It should offer the business some protection against one of the founders leaving to set up in direct competition. But the inclusion of one of these clauses shouldn’t be seen as the only type of IP protection needed, nor completely enforceable.