This article has been written by Simranjeet Kaur, pursuing a Diploma in Law Firm Practice: Research, Drafting, Briefing and Client Management from LawSikho. It has been edited by Ruchika Mohapatra (Associate, LawSikho).
A shareholder agreement is an arrangement that defines the relationship between shareholders and the company. The agreement safeguards the rights and obligations of the majority and minority shareholders, and it ensures all shareholders are treated fairly.The shareholders of a company will have detailed knowledge of the company’s intellectual property and trade secrets, business plans as well as relationships with key stakeholders and access to customer lists as well.
Therefore, it is crucial to protect the inside information of the company and here comes the importance of non-compete clauses in the shareholder’s agreement. These non-compete clauses protect the company from any form of competing business to use their information and compete against them.
Non-compete clauses protect while exchanging any confidential information. A company must ensure that their information is not being used to set up a rival company by any such person with whom the information is shared or for the purpose of sharing such information to a competitor, etc. Therefore, non-compete clauses hold utmost importance in business agreements.
A non-compete clause restricts the shareholder to a business agreement from carrying on the same business in future after exiting from the target company, for some time. In a shareholder’ agreement, non-compete clauses put a restrictive covenant to protect the company by limiting any future competitive business activities by the shareholder after his exit from the company, for a given period.
If there is no non-compete clause in an agreement, then the shareholder would be free to take an exit from the company and just share the information with any rival business or set up his own new company.
The sample of a non-compete clause in a shareholder’s agreement is given below:
Non-Compete: “During the Term of this Agreement, and for a period of 2 years after termination or expiration, the Shareholder agrees that he shall not,
- start any new business which is similar or identical to the business model, product or services provided by the Company;
- directly, or indirectly, engage as a Shareholder, employee, sole proprietor, member of partnership, investor, consultant, director, or officer of a company, or as an associate, or be an agent of any person, business organization or entity which is a competitor (or any person or entity that is reasonably anticipated to the general knowledge of the Shareholder or the public to become a competitor) of the Company”.
It can happen that after exiting the company, the shareholder may not set up a new company, but he may solicit the clients, employees, etc of the company for his or her own direct or indirect gain. Therefore, a non-solicit clause provides a safety net for any company, thereby, restricting the shareholder to set up a business with the company’s rivals or engaging with the clients, employees, etc of the company after his or her exit.
A non-solicit clause is a restrictive covenant in a shareholder’s agreement that limits the ability of the shareholder to communicate and conduct business with the clients, employees, or suppliers of the target company for a specific period, after his exit from the company.
The following is a sample non-solicit clause in a shareholder’s agreement:
Non-Solicitation: “During the Term of this Agreement, and for 2 years after termination or expiration, the Shareholder shall not, directly or indirectly, and without the prior written consent of the Company,
- solicit or attempt to solicit, induce or attempt to induce, any person who is at the time of such solicitation or attempted solicitation (a) an employee, supplier of the Company to terminate their employment, supply, with the Company or any (b) prospective employee with whom the Company has had discussions or negotiations within six months prior to the termination of the Shareholder’s agreement, not to establish a relationship with the Company;
- induce or attempt to induce any current customer to terminate its relationship with the Company;
- induce any prospective customer with whom the Company has had discussions or negotiations within six months prior to the termination of the Shareholder’s agreement, not to establish a relationship with the Company”.
Negotiating a non-compete clause in a shareholder’ agreement
A majority of the shareholders who are looking to expand their business by bringing in new partners will want to incorporate a non-compete clause to protect the value they have built in the business and its long-term prospects. Similarly, anyone who is buying shares out of the majority shareholders will want to ensure that the former owner cannot set up a rival company, after exiting from their business.
While drafting a non-compete clause in the shareholders’ agreement, it is crucial to specify and narrow the commercial activity that is considered to be competitive according to the company. Setting up a new company and offering the identical goods or services would be competing in nature. But substitute goods or services may be less clear unless expressly and unambiguously defined in the agreement.
The following factors must be taken into account while negotiating for a non-compete:
- Duration of a Non-Compete Clause: The non-compete clause prohibits or restricts the shareholder from engaging in any competing business for a specific period. Such a time must be favourable and not unreasonable. For example, a non-compete that restricts the shareholder from engaging in any competing business around the world for a period or 20 years is very unreasonable. But, a restriction of not competing anywhere around the world for 6 months or 2 years is favourable enough.
- Geographical Location: It refers to the area in which any competing business activity is restricted by the Company. The geographical limit should not be unreasonable and arbitrary. The non-compete must mention all such locations wherein, the company has its outreach, along with a reasonable period.
- Compensation: In case of breach of the non-compete, the shareholder must pre-determine the suitable amount of compensation to safeguard himself from any litigation in the future.
- non-solicit clause: By inserting a non-solicit clause for a reasonable period would help in limiting the shareholder’s ability to solicit the customers, employees, suppliers, etc of the company.
- Non-ambiguous terms: The non-compete must be drafted in a way that no ambiguity or confusion should be there. The terms mentioned should be clear and crisp.
Enforceability of non-compete clauses
In India, Section 27 of the Indian Contract Act, 1872, provides a restraint on any business that puts a restriction on trade. This way, it appears that all non-compete clauses are invalid in India. However, the Hon’ble Supreme Court of India has explained that some non-compete clauses are in the interest of trade and commerce and therefore, they cannot be treated as invalid.
In the U.S.A, non-compete clauses are valid but in some of its states, such non-compete clauses or agreements are invalid.
In the U.K, such clauses are called restraint of trade and may be used by the employer, if only he can prove a legitimate business interest to protect in entering the clause into the contract and mere competition will not amount to a legitimate business interest.
In the case of Maseco S.A. vs. Herbert  EWHC 3326 (Comm), the respondent challenged the application on the basis that the non-compete restriction was too broad and therefore, unreasonable and the settlement agreement waived the non-compete restrictions in the shareholder; agreement. He said that the terms of the Settlement Agreement, stated that the agreement was “intended to settle outstanding differences” between the employee and any company; and also stated that the parties “declare[d] expressly that none of them will have any obligations regarding the other Party”. He contended that this waived the non-compete and that Ideal Standard had signed the Settlement Agreement for, and on behalf of, all group companies. However, the court thought that there was no reference to the settlement agreement to the shareholder’ agreement and also the shareholder agreement clearly stated that any waiver must be in writing and duly signed by the person who is granting it. Hence, the court granted an interim injunction as prayed in the application.
In Guest Services Worldwide vs. Shelmerdine  EWCA Civ 85, the appellate court upheld the decision of the lower court for the 12-month post-departure restraint and rejected the arguments stating that the outgoing personnel risked being locked in for an indefinite period, if unable to sell their shares.
It can be concluded that the non-compete covenants must be drafted very carefully in any agreement. However, it is also important that the terms of the non-compete must be fair and just. The terms must be mentioned clearly and unambiguously in order to avoid any loopholes in case of any future litigation. In drafting a strong non-compete in a shareholder’ agreement, one must clearly articulate the nature of the company’s business to clarify what is considered to be competing by them. The drafting of a non-compete clause can be a tricky part of a shareholder’ agreement.
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