This article has been written by Sumer Karekar, pursuing a Diploma in M&A, Institutional Finance, and Investment Laws (PE and VC transactions) from LawSikho.
“Tact is the ability to tell someone to go to hell in such a way that they look forward to the trip.”
Understanding non-compete clauses in investment agreements
An investment agreement is a contract executed between two parties that outlines the rights, liabilities, powers, and obligations of the investor and investee involved in the transaction. The agreement expresses the intention of the investor to invest in the target company, along with what the investor seeks in return, i.e., shares, voting rights, control over the management, participation in decision-making, etc. Investment agreements are primarily of three types;
- Shareholder’s agreement – An agreement executed between the shareholder and the company that highlights the terms of the transaction and the rights and responsibilities of the shareholder.
- Share purchase agreement – An agreement entered into between an existing shareholder of the company and a new shareholder, who seeks to buy out the stake owned by the existing shareholder. The agreement explains the terms and conditions of the purchase of shares and enumerates the rights and duties of the incoming shareholder.
- Share subscription agreement – An agreement executed between the company issuing shares and an investor who seeks to subscribe to fresh shares of the company.
In all such agreements, the investor attempts to protect his position as a shareholder of the company, while simultaneously seeking to make a profitable exit in the future. While investing money in a company and holding the position for the long term before ultimately exiting with lofty returns may sound rather simple, investors are compelled to foresee all plausible threats and hurdles that may arise during the period of investment. One of the most common concerns while executing investment agreements, amidst ensuring the founders’ commitment to the business and preventing the dilution of the investor’s stake in the business, is the regulation of potential competition, if the founders choose to subsequently sell their stake and exit the company.
What is a non-compete clause?
Let’s consider an illustration for the purpose of clarity. Suppose A seeks to invest and hold shares in Company B. After completion of the formalities, A invests a substantial sum of money in Company B, expecting it to perform well and secure him a profitable exit in the long run. However, a few months after the investment, the founder of Company B sells off his shares and exits the company. Soon after the exit, he incorporates Company C, engaging in a competing business, and uses his skills, clientele, and strategies to continue business operations. With the transfer of the founder’s abilities, his clientele, and the reputation of the business from Company B to Company C, A would face significant losses and the founder’s immediate exit would defeat the purpose of his investment.
In consideration of such a scenario, investors seek to add clauses to the investment agreement to protect their shareholding and prevent the founders from engaging in a competing business if they eventually choose to exit from the investee company. Non-compete clauses are restrictive covenants inserted in an investment agreement to protect the investment of the buyer by limiting any future competitive business activities by the seller after his exit from the target company, for a given time period. Through such a mechanism, the investor safeguards the goodwill of the business, along with its customer base, supplier network, employee relations, and other key stakeholders, irrespective of whether the founder sells off his stake in the company or not. Without the insertion of a non-compete clause, the investee-founder would be free to exit the target company with a profit and merely transfer the network, reputation, and credibility of the business to a new company.
While the founder may not conspicuously set up a competing business after his exit, he may indulge in the solicitation of the suppliers, customers, or employees of the target company, thereby draining its intellectual and operational capacity. Losing trusted employees or key suppliers of the investee company have a direct impact on its performance, operations, credibility, and its position in the market, as a result causing significant losses to the investor in the long term.
In order to protect the investment and the market value of the target company, investors seek to insert a non-solicit clause, in addition to the non-compete clause, to ensure that the founders do not set up competing businesses or engage with the suppliers, employees, or clients of the investee company upon their exit.
In brief, a non-solicit clause is a restrictive covenant in an investment agreement that limits the ability of the founder to communicate and conduct business with the clients, employees, or suppliers of the target company for a specific period of time.
Negotiating a non-compete clause in investment agreements
Making a profit from investing is all about understanding and managing the risks involved and thus, investors put in the time and effort to negotiate and mitigate all plausible threats to their investment. Clauses such as a non-compete, a non-solicit, a lock-in period, the right to pre-emption, the right against dilution of shareholding, etc. are all different kinds of protective mechanisms inserted in an agreement to safeguard an investment from foreseeable risks.
However, most of these clauses protect the interests of the investor at the inconvenience of the founders of the target company. For example, although a ‘founder lock-in’ clause seeks to ensure the commitment of the founder to the growth of the investee company for a longer period, it restricts the founder’s right to sell his shares and exit the business before the stipulated period has lapsed.
Therefore, such restrictive and obligatory covenants in an investment agreement must be carefully considered and negotiated by all the parties involved, before inking their signature on the dotted line. Understanding the interests and motives of the parties involved can enable them to negotiate more effectively.
The intention of the investor
The primary goal of the investor, especially when it boils down to small or medium-sized companies and start-ups, is to fund the operations of the company in return for ownership of shares and certain other limited rights. After the company increases in value over a period of time and decides to go public, the investor usually seeks to sell off his stake and exit the company with a profit. However, as discussed previously, the value of the investee company and the investment made is prone to threats from several factors during the germination period, especially, in several cases, from the founders themselves.
While entering into an investment agreement, the investor is usually mindful of the value derived by the business from the relationships of the founder with his suppliers, customers, employees, etc., his reputation as a creator, and his knowledge and skills. In consequence, the investor also recognises the hazards attached to the premature exit of the founder and the establishment of a separate competing business following the acquisition.
Therefore, the buyer would prefer that every term in the non-compete and non-solicit clause is defined as broadly as possible while still being legally enforceable, with fewer exceptions. He would want to impose a long time period during which the existing founder cannot carry out a competing business, coupled with several other elaborate conditions, restrictions, and ‘events of breach’ clauses.
Negotiating for the investor
As mentioned above, the investor seeks to impose heavy restrictions on the founder’s right to indulge in a competing business upon his untimely exit from the investee company. Therefore, while negotiating a non-compete, the investor must take the following factors into account:
- Duration of the non-compete clause – The non-compete essentially prevents the existing founder from engaging in a competing business for a period of time. The period must be favourable enough for the target company to grow and increase in value, thereby allowing the investment to mature without any hiccups. While negotiating the non-compete, care must be taken to ensure that the time period is not reasonable and falls within the confines of the law.
- Section 27 of the Indian Contracts Act – This provision regulates covenants that impose unreasonable limitations on the right to conduct trade or business. However, it expressly excludes agreements wherein the goodwill of a business is sold, in which case reasonable restrictions may be imposed. It is crucial for the buyer to understand the rationale adopted by the judiciary in different cases, so as to effectively negotiate a legally binding non-compete period, that favours the growth of the company and the maturation of his investment.
- The phraseology of the non-compete clause – Every such clause must be tailor-made to suit the particular requirements of the parties, keeping in mind the nature of the business and all foreseeable factors. Thus, merely editing a sample template of the clause is discouraged.
Further, the investor must ensure that the words used in the clause offer ample generality and breadth to prevent, directly or indirectly, the founders or his affiliates or associates or any such persons or classes of persons, from carrying out a competing business after their exit from the investee company.
- Geographical location – Besides periods of non-competition, emphasis must be laid upon the geographical location within which the competing business shall not be carried out. To negotiate effectively, the investor must conduct research and understand the geographical outreach of the founder, the investee company, and its business. Mentioning all such locations in the covenant, along with a suitable time period can protect the investment from potential diminution.
- Remedies and compensation – The investor must study the valuation of the business and arrive at a suitable amount of money that can be contractually claimed as compensation in the event of a breach of the non-compete covenant. Pre-determining the quantum of compensation could safeguard the investor from prolonged litigation in the future.
- Accompanying clauses – While the non-compete can be effective as a standalone clause, inserting additional complementary clauses can result in a watertight agreement. Investors must negotiate to add a favourable “founder lock-in” clause which prevents the founder from selling his shares and exiting the company for a stipulated time period. Besides, inserting a broadly-worded “non-solicit” clause can further limit the founder’s ability to poach the customers, employees, or key suppliers of the investee company, in the event of his exit.
Negotiating for the founder/promoters
While most non-compete clauses are drafted to ensure the commitment of the parties to the vision of the company and its development, certain investors may use the covenant to strong-arm the founder and barricade his rights to conduct business freely. To effectively negotiate a non-compete clause, the founder must take into account the following factors:
- Duration of the non-compete clause – The founder must possess profound knowledge about the nature of the business and the market, and his post-exit plans, to be able to negotiate a reasonable non-compete period. He should aim at maintaining a minimal duration and may seek to add several exceptions to the clause to allow him greater liberty in the event of his exit. For example, he may agree to not compete directly with the business of the investee company for a period of four years, but he should be free to invest in direct competitors of the company. Additionally, understanding Section 27 of the Contracts Act shall allow him to recognize the voidability of certain non-compete restrictions and negotiate them effectively.
As a common standard, a non-compete clause may restrict competition for a duration ranging between 3 to 6 years on an average within specified territorial limits, depending on the nature of the business, its operational capacity, and the prevalent market conditions.
2. The phraseology of the non-compete clause – The seller must exercise immense caution while examining the words and definitions used to frame the non-compete clause. He must look out for words that enlarge the scope of the restrictions imposed, vague and ambiguous terminology, definitions that expand the ambit of interpretation of the clause or phrases that signify that the clause is non-exhaustive in nature. The seller should push for narrower definitions and exhaustive phraseology. As a beneficial practice, the seller may prepare a separate non-compete clause and compare it to the clause proposed by the acquirer, thereby weeding out inadequacies and enhancing clarity.
3. Geographical location and jurisdiction – The seller must ensure minimal geographical applicability of the non-compete clause. He must study the reach and network of his business to negotiate effectively and must exercise vigilance with regards to widely-phrased terms and restrictions in the covenant.
4. Remedies and compensation – While predetermined damages are beneficial in times of litigation, the founder should insist on non-exhaustive phraseology with regards to compensation. The compensation should be reasonable and dependent upon the nature of the breach and the true damage incurred by the aggrieved.
5. Accompanying clauses – Adding a “founder lock-in” or a “non-solicit” along with a non-compete is a standard practice carried out by investors to protect their investment from losses, especially losses resulting from the activities of the founders. The seller must ensure that the phraseology of the clause does not allow an excessively wide scope of interpretation. For example, the seller may demand that every stakeholder mentioned in a non-solicit clause be specifically defined and the wording of the clause is exhaustive. Similarly, the founder must negotiate a lock-in clause to impose a reasonable time period and to mention clearly, the percentage of shares the founder shall be entitled to sell after the stipulated duration.
Additionally, the founder may impose a few obligations upon the investor with regard to breach, mala fides, or unethical conduct.
Negotiating a non-compete clause requires a sound understanding of the nature of the business, its operations, key stakeholders, its credibility, and reputation. All parties involved must ensure that the non-compete is tailored to their legitimate interests. Sellers, in particular, must exercise caution and recognise where the acquirer seeks to impose unjustifiable barriers to their right to conduct business post-exit.
Enforceability of non-compete clauses in investment agreements
Non-compete clauses in investment agreements are a common protective mechanism employed by the investor to safeguard the market value of the enterprise. However, in light of the Indian Contract Act, 1872 (“Act”), acquirers must be careful about imposing restrictions that may be deemed legally unenforceable or an unreasonable limitation on a person’s right to carry on business or trade. Therefore, to be able to effectively negotiate a legally binding non-compete clause, the acquirer must understand the relevant legal provisions and the stance of the judiciary pertaining to restrictive covenants in investment agreements.
Section 27 of the Act provides that a contract in restraint of trade is void. The courts have commonly applied this provision while examining contracts of employment, where the employer seeks to prevent the employee from working with a competitor post-termination. In the case of Wipro Limited v. Beckman Coulter International S.A. The Delhi High Court held that negative covenants restricting the employee’s right to seek employment or conduct business in the same field would be in restraint of trade and therefore, void. Further, in Percept D’Mark (India) Private Limited v. Zaheer Khan and Others, the Supreme Court concluded that a restrictive covenant extending beyond the term of the agreement shall be void and unenforceable.
In Gujarat Bottling Co. Limited v. Coca Cola Co., the apex court held that the test of reasonableness and the principle of partial restraint shall be applicable only if the covenant falls within the express exception of Section 27 of the Act. As discussed previously, the exception can relate to the sale of the goodwill of a business under an investment contract, wherein the founder agrees to preclude altogether, for a stipulated period of time, from exercising his right to carry on a competing or similar business, within specified geographical limits of the investee company. In the Gujarat Bottling case, the Supreme Court made the following observations:
- The scope of Section 27 of the Act extended beyond only employment agreements and covered all or any covenants that were directly or indirectly restrictive of business;
- Since such restrictive covenants are essentially in restraint of the fundamental right to carry on trade or business, they must be reasonable with respect to public policy and must patently necessary for the protection of the interests of the acquirer;
- The burden of proof lies on the party defending the terms of the covenant to establish, beyond a reasonable doubt, that the restraint does not extend beyond what is essential to protect the interests of the buyer. If the buyer successfully justifies the necessity of the covenant, the onus shifts upon the seller to sufficiently prove its unreasonableness and its detrimental impact on public policy.
- It is for the courts to adjudicate, as an issue of law, whether the covenant is directly or indirectly in restraint of trade and whether the limitation imposed is reasonable and legally enforceable.
While most investment agreements focus on the collective benefit of all the stakeholders involved in the transaction, a covert attempt to strong-arm the seller (or even the buyer in certain cases) through a cleverly drafted non-compete covenant is not uncommon. Especially in the market abundant with cut-throat competition, it is key for founders and investors to understand their options, study the phraseology and applicability of their agreements and negotiate assertively to avert risk and conflict.
Investors must be careful about not imposing unreasonable restrictions upon the founder’s right to conduct business, which may be deemed unlawful. They must possess thorough knowledge about the reputation, outreach, and network of the business along with the abilities of the founders, to tailor a precise and robust non-compete. Similarly, founders and promoters must consider the intention of the investors and should negotiate out of long non-compete time periods and broad geographical restrictions. They must push for narrower, more well-defined terms and exhaustive phraseology while examining non-compete covenants. Lastly, possessing sound awareness of the relevant provisions of the law and their judicial interpretation can translate into a substantial advantage during negotiation.
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