Shareholder Agreement Essentials: Non-Compete Clauses

Non-compete clauses are a well-known provision found in employment contracts.  But they also should be part of a business’ shareholders’ agreement as well.   Non-compete clauses for employees have a reputation for being very difficult for employers to enforce as the Courts often view the specific requirements of the clause to be unreasonable.  The opposite is true when it comes to non-compete clauses between shareholders.  In these circumstances, the Courts will typically support the existing business instead of the shareholder who has left the company.

Most shareholders of a business 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.  Non-compete clauses in shareholders’ agreements are designed to protect and benefit all the shareholders by preventing any of the owners from using that insider information to start a rival business or contribute to a direct competitor.  A majority shareholder looking to grow the business by bringing in new partners should use a non-compete clause to protect the value they have built in the business and its long-term prospects.  Likewise, anyone buying out a majority shareholder will want to ensure the former owner cannot set up a competing shop upon their exit. 

While the Courts do tend to look favourably on existing business owners in non-compete disputes between shareholders, there are of course limitations to how severe the terms of the clause can be.  Typical restrictions focus on the length of time the departed shareholder must wait before competing and the geographical restriction as to where the former shareholder cannot operate a rival company.  Often, the greater the scope of one restriction the lower the other must be to remain reasonable.  For example, a non-compete that prevents a shareholder from competing anywhere in the world for ten years would likely be viewed as unreasonable.  But a restriction of not competing anywhere in the world for six months would likely be viewed favorably. This type of clause is typically seen in larger businesses, especially in the technology sector where the pace of change over a six month period can be significant.  For businesses in the retail sector, the geographical limitations would be much smaller, but the length of the time in which a partner is prevented from competing could reasonably be several years.

When preparing the non-compete clause of the shareholder agreement it’s important to specify the type of commercial activity that would be considered competing.  Starting another company offering the same goods or service would clearly be competing, but what about working for an existing competitor or providing consulting services to a competitor?  The shareholders’ agreement should also clearly articulate the nature of the company’s business so that activity that is competing can be easily identified.

The ideal time for shareholders to decide what would constitute fair and reasonable non-compete terms is when the shareholders are working effectively together for the good of the business.  Should a dispute arise in the future that leads to the departure of a shareholder, the shareholders’ agreement will provide the non-compete requirements that all parties, including the departed shareholder, agreed is fair and appropriate.

André Munroe