There comes a point in the journey of most medium-sized companies where it is time to bring in new blood. Perhaps, to ensure a great employee stays with the company, or, perhaps, because the founders want to begin winding down their involvement. The key document to be negotiated in such a situation is the shareholders’ agreement, which will govern how the shareholders interact with each other, and with the company. An important provision in such a document, which is often skimmed over, is the restraint of trade, or non-compete, provisions. It is vital for a shareholder to understand fully what their position will be if they exit the shareholding of the company at some later date.
Whilst restraints of trade are most commonly thought of in relation to an employment agreement, restraints of trade are also a feature in shareholders’ agreements. In the context of a shareholders’ agreement, these restraints generally prevent a shareholder from being financially interested in a competing business during the time that the shareholder is a shareholder, and for a period of time after the person ceases to be a shareholder. The important point for a shareholder to consider when reviewing the restraint clause is whether the restraint would be reasonable if the shareholder left the company but still wanted to work in the industry.
The starting point for a restraint of trade clause is that, like its employment agreement contemporary, it is presumptively unenforceable, as it prevents a person from earning a living in their chosen industry. However, this presumption can be displaced where the restraint of trade is shown to be reasonable. In a commercial context, such as a shareholder agreement, the courts are more willing (than in relation to an employment agreement) to find that a restraint is reasonable due to the more equal bargaining powers of the parties and the abilities of the parties to take legal advice. Accordingly, it is important that a prospective shareholder gives due consideration to the restraint of trade, even though (in an ideal world) they will never exit the company, as they will likely be stuck with the restraint once they sign the shareholders’ agreement.
The first question for a shareholder to ask themselves is whether, if they were to cease being a shareholder, could they continue working in their chosen field and geographic location. Often the answer will be no, so the shareholder should consider whether the length of time and geographic restriction is acceptable. There is no magic formula for this. However, the geographic area should be no wider than the area in which the company primarily operates, and the time period should be no longer than is necessary to give the company the opportunity to protect their customer base and commercial operation. Six months to a year is not uncommon.
For an incoming shareholder, there are a few additional common fishhooks to consider. First, often the restraint of trade will apply to any related party of the shareholder as well as the shareholder. Related parties are often defined to include any family member of the shareholder. So, if such a provision is included, you will need to confirm that you do not have any family members who are employed by, or otherwise involved in, any competing company.
Second, a common involvement in a competing company which may be overlooked is owning shares in a competing publicly listed company. If you work in an industry where some of your competitors are publicly listed (i.e. on the NZX or similar), and you own shares in these competitors, then this will breach the restraint of trade unless there is a clause which expressly carves out ownership of publicly listed companies.
The final fishhook to consider is the situation where a shareholder is also employed by the company. In such situations, the restraint period generally starts from when the shares are sold (rather than when the employee ceases to be employed). However, if the shares are sold because the employee has resigned (a common requirement) then the shares may not be sold until a reasonable amount of time after the employee has resigned due to the company having to find a buyer and then that buyer obtaining the necessary funds to purchase the shares. If a conflict arises in relation to the sale of the shares (perhaps, due to a dispute over their value), then it may take even longer to sell the shares than would ordinarily be the case. All of this has the effect of extending the period in which the person is restrained from being involved with a competing company. And, it has the effect of extending the restraint period beyond the period which the shareholder probably contemplated when considering the term of the restraint of trade. Accordingly, it may be prudent for an incoming shareholder, who is also employed by the company, to ask that the restraint period begins from the date that they resign their employment.
If you are considering buying into the company you work for or you are a company which is considering selling shares to its employees, then feel free to contact a member of our team who will happily assist you ensuring your shareholders’ agreement performs as you wish it to.