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.

A liquidation preference clause is usually incorporated into a shareholders agreement by a professional investor (such as a business angel or venture capital firm) as a risk reduction tool in case the business fails but still has value in it, or to give particular shareholders a superior return over others on a profitable sale. For the investor, it is usually one of the most important terms to negotiate because it largely defines the outcome of investment.

The preference term sets out how the remaining value of the company is shared between the equity owners when a liquidation event occurs. That could be a negative event such as bankruptcy, but it could also be any other time where shareholders receive money for giving up equity, such as on acquisition by another company. Some shareholder agreements also define a liquidity event as the sale of “substantially all the assets”.

The preference clause should cover two pieces of information: who receives the right to a greater return, and what that return is.

Professional investors usually buy a particular issue of equity, such as “Preferred Series A” because doing so allows rights to be tied neatly to that stock. As a result, “who” receives the right to a preference is commonly defined by reference to share classes. However, there is no specific need to do this – you could refer to a specific investor by name.

The return might be a straightforward multiple of the share price paid (such as one and a half times the price) before the other shareholders are paid, or it may be on a pro-rata basis with other share class owners until a cap has been reached. The first is known as full participation, and the latter is known as capped participation. Non-participating describes those shareholders who do not hold the right at all. Capped participation favours the founders more than full participation because as “other shareholders”, the founders benefit at the same time as the investor, and not just once the investor has had his return goals met.

There can be added complications if there are multiple institutional investors and multiple financing rounds. Preference can be stacked on top of each other, so that later investors have rights to be repaid before earlier ones. How this is done is largely a matter of negotiation between investors.

If the liquidation event is a conversion of one type of share class to another, then investors might have secondary or tertiary “dips” at returns. They might have the right to receive a multiple of price paid at the first conversion, and a secondary right to receive another multiple when the new shares they acquire are later sold or converted.

Liquidation preference clauses are usually only used by professional investors. So as a founder looking to put in place a shareholders agreement with other founders, this isn’t a clause that we would say that you need to have. However, it is useful to understand how one works.

In a young business, the founders are likely to be both the owners and the managers of the business – the shareholders and the directors.

How decisions are made differs between the board meeting and the members’ meeting.

The directors of most start-ups vote on board level decisions on a show of hands. That means each director has an equal vote regardless of whether he or she owns equity, or how much.

By contrast, most shareholder motions are carried based on the approval of the shareholders who between them carry the majority of the equity. That rule can be varied by mutual agreement between them all, but in general, it is the larger shareholders who sway the decisions.

This difference means that any large shareholder, such as an angel or venture capital investor, is likely to want at least one seat on the board in order to keep some control of the company between shareholder meetings. The founders might not want to give more control of the company to the investor (who already has significant power as a shareholder). The question then becomes: how should the investor participate in board decisions?

One way of doing that is for the investor to have the right to appoint at least one non-executive director. That person wouldn’t be a management-level employee of the company, but rather simply someone who can express the opinion of, and vote in the interests of the investor.

Founders (or indeed other investors) might not agree that the investor should have board level voting power. A compromise is often that the investor can appoint an observer to the board instead. The observer has the right to attend meetings, to speak (express his or her opinion) and to listen, but doesn’t have the right to vote.

Observers seem to be a harmless compromise. But there are many reasons why founders should be wary of giving observer rights to an investor.

An argument for appointing an observer is that he or she can bring additional knowledge to the debate. That might be the case. If the observer also has sat as an executive director on the boards of other companies, he or she is likely to have a great deal business experience and a network of contacts. But it might also not be the case. Because it is the investor’s decision as to who to appoint, founders may find themselves with someone with little operational experience who wants to be seen to be talking for the “most important” shareholder. That person may be difficult to get along with, may distract the directors from day to day business, and may not understand what the founders intended the business to do. Although the observer might have invaluable knowledge, but just because he was appointed by a professional investor, doesn’t guarantee that.

A second argument is that investors should have a right to know what is happening in the business. That is a valid point, but not one solved by having an observer on the board. The solution is to give “information rights” – the right to have a face to face meeting with certain executive directors every quarter where any matter can be discussed. If an investor has information rights, then having an observer shouldn’t be necessary.

An effective board of any company should consist of members who vote independently. That doesn’t necessarily mean that directors should listen to the opinions of other members of the board, but rather that they shouldn’t follow the leader.

In practice, founders tend to look to an experienced investor for advice. They also tend to be in agreement on many issues, so opinion is unanimous and voting is not required to make a decision.

That means that even as an observer, an investor who can speak at a board meeting can have a disproportionate influence on the board (almost the same power as a non-executive director). It is hard to disagree with someone who is funding your dream, especially if they have been there before. To be cynical, if you are looking to make sure you always meet your fiduciary duty to the company and the shareholders, then voting in the way the largest of the shareholders wants is not likely to land you with problems.

An observer could be asked just to observe, and not to speak. Often venture capital companies bring in a less experienced employee of the firm, to be trained up to a position where he can himself sit on the boards of investments. The directors may have no issue with this, but there shouldn’t be a need to have a right to do this. The VC firm should simply be able to ask the directors whether they mind.

Lastly, there is a practical argument why you should not have observers to board meetings. It isn’t a particularly strong one, but could be valid. It is that many voices in a meeting take time to hear and can side-track the meeting. With a strong chairman and an agenda, this shouldn’t happen, but it could be a risk.

Should you grant other shareholders observer rights?

Good advice is never to let anyone attend board meetings that you wouldn’t value as a board member. Don’t let someone sit in an empty seat. Make sure you know who is taking that seat and what value he or she brings to the discussion.

If you are undergoing a financing round, observer rights might be something you have to concede to bring in investment. It might be better to concede an observer position than a non-executive directorship. But make sure you agree on certain terms.

What should be in your agreement?

Observer rights might be granted as terms in the shareholders agreement, or in a separate investor agreement.

Parties to the agreement, and the name of the observer

The company and the investor are the main parties to the agreement. But even if the observer is a representative of the investor, he or she should be specifically named (perhaps in a secondary agreement so as not to have to amend the primary agreement if the identity of the observer changes).

If the investor wishes to change who the observer is, then all observer rights should be temporarily suspended until the new observer is named or otherwise brought into an agreement.

Notification of meetings

Board observers have no statutory rights to be notified of meetings, unlike directors. So that right needs to be given contractually instead.

Restrictions and process

There may be restrictions on which types of meeting an observer may attend, or for he or she will be given notice. There may also be a process that must be followed for the observer to be allowed to attend, for example, the observer must give notice that he or she will attend within a certain timeframe.

Information rights

An investor may also want the right to receive all notices, reports, documents and minutes relating to a meeting. If so, this should be specifically agreed. However, also in place should be confidentiality clauses to protect sensitive information.

What are these clauses?

Deadlocks provisions are terms that are incorporated into shareholder agreements in order to provide methods for resolution of issues over which owners cannot agree.

Because we are dealing with shareholder agreements, typically these issues relate to the management, control, direction or strategy of the company. They are important enough to all owners such that no individual is willing to move from his position and compromise.

These decisions should also be so important that the business becomes paralysed without a decision having been made. The principle behind them is that the ability of a company to trade (and therefore its value) should not be allowed to deteriorate because of indecision.

When are they used?

A shareholder agreement might limit the circumstances in which certain deadlock provisions can be used, for example, only on issues relating to the sale of shares to a third party, or they might be able to be called upon for any matter. Sometimes, the provisions are so severe to one side that the threat of being used is sufficient to change the stance of one owner and for the issue to be resolved.

Deadlock can usually only be announced after a number of votes have been taken, and the outcome of those votes is indecisive. For example, a key matter might have to be raised (and voted on) in three consecutive meetings before deadlock clauses can be brought into play.

Just as in any dispute, before a severe solution is forced, alternative methods of resolution should be encouraged. Mediation – a process where an independent third party leads discussions between the parties with the aim of finding a solution – is often a requirement before deadlock provisions can be invoked.

Different types of deadlock provision

Deadlock clauses usually require one shareholder to sell his or her shares to the others so that he or she no longer has control over the company, allowing the remaining owners to vote through a decision.

These are types of conditional termination provisions, and there are as many different variations for different situations as lawyers can invent. However, there are some common ones:

Russian Roulette is where one owner names an all-cash price at which he values his share of the company. The other shareholder (or shareholders) must then either buy the first owner out at that price, or sell his own shares.

A Texas shootout is effectively an auction, where the owners send sealed bids to an adjudicator. The sealed bids are opened at the same time, and the shareholder who has stated the highest price (i.e. the one who values the shares most highly) must buy the other out.

A Mexican shootout is a dutch auction. The shareholders make sealed bids stating the minimum price for which they would sell their shares. The owner who values the shares most highly must buy the shares of the other, but at the price set by the loser.

Multiple choice procedures are those where the shareholder agreement gives the shareholders many options for resolving disputes, and allows them to agree on the use of one for the particular situation. The idea is that agreement might be found in choice of method, and with the severity of the means of resolution in the minds of the shareholders, compromise on the issue at deadlock might be found. Multiple choice procedures get owners back to a position of agreement (at least on one issue).

Should you include deadlock provisions into your shareholder agreement?

Deadlock provisions are effective in so far as they break deadlock.

However, resolving a deadlock by using one of these provisions is rarely valuable for a company, and this is especially so for a small or young company.

The shareholders are likely also to be directors of the company on a day to day basis. Founders who are directors are likely to have key skills that the business needs to grow. Take one away through forced buyout, and the company could suffer more than if a decision on some matter hadn’t been made.

If there is such severe disagreement, founders are likely to seek other ways out of the business without having to resolve to using draconian deadlock clauses. In other words, if the going is so bad, so early on, it is unlikely that founders will want to remain shareholders.

These sorts of terms are often designed to “punish” one side over the other in order to be deterrence. That isn’t always fair, especially when both sides think that their position is principled. Shareholders will take a stand on an issue because it is important to their vision of what the company should be doing. Because the idea of using deadlock clauses is to prevent a deterioration in value – to keep the business running – shareholders, and especially founders aren’t going to put their company in a dangerous position unless the alternative was perceived to be worse.

Lastly, a shareholder may not have the money to buy the other out. It is all very well to fix a price on the company at which you will be willing to sell your shares, but if the other side doesn’t have or cannot raise the capital to purchase there isn’t a lot that can be done.

So what should you do instead?

A better way to resolve dispute, rather than include deadlock provisions, is to make sure that deadlock cannot occur. The ways of doing that include:

• making sure that one or more owners always have more shares and therefore more voting rights than others (for example, splitting the ownership of the company in a ratio of 51:49 rather than 50:50)
• making sure that the basis on which certain decisions are made is not based on shareholdings (for example, in a company where two founders own the equity 50:50, a shareholder who has invested debt as well as equity might have 2 votes on any issue relating to capital purchases over a certain amount, whereas the other shareholder would have 1 vote)
• appointing a third party to have a casting vote (such as a director trusted by both shareholders, who herself is not a shareholder)

Share ownership cannot be controlled through a shareholder agreement, but these other solutions can.

The short is that while deadlock provisions have intriguing names that suggest a sophisticated agreement (great If you are a lawyer working on behalf of a client you want to impress), you don’t need these clauses to resolve disagreement. There are other, simpler ways of avoiding deadlock that are probably more beneficial for the owners and the business.

Should you include a tag along clause in your shareholder agreement?

More and more founders are insisting on including tag along clauses in their shareholder agreements. The following is a quick explanation of what one is, and why you might use one.

What are tag along rights?

A tag along provision gives a shareholder the right to force a buyer to buy his or her shares on the same terms and in addition to any other shares.

The inclusion of this clause gives a shareholder comfort that if any other owners decide to sell, he or she can also exit from the company at the same time.

The reason why this might be advantageous is usually because any new owner is likely to want to change the direction of the company in some way. The existing owner, especially if he is a founder, might not agree with the new objectives, but might not otherwise be in a position to veto those changes. A tag along provision gives the existing owner a way of getting out of the business while the going is good (in his or her eyes).

When is a tag along provision used?

Most founders don’t include a tag along clause at the outset of their relationship. It is usually only inserted into a shareholder agreement when an institutional investor such as a business angel or venture capital firm invests.

Professional investors usually want to build a company and sell it on within a short time frame. That strategy might suit the founders well. But the next buyer might want to do something else with the business. Since any professional investor is likely to buy a majority stake, the founders might not have much say over who the second buyer is, or which direction the business takes after the second sale.

So the founders might agree with the institutional investor to include a tag along provision in their shareholder agreement. The clause does not affect their relationship in any way – it just gives the founders a means of exit next time round.

Are there any disadvantages to including one?

A tag along clause is beneficial for founders – especially for those with minority interests. Professional investors are likely to have much wider sales networks and thus should be able to find an attractive price for the shares. Plus, those investors will sell reasonably soon. The clause benefits minority owners by allowing them to piggy-back on the deal the professional makes (importantly, if they want to). That means they can continue with running the business rather than finding buyers or negotiating terms.

A professional investor also benefits. Not only will the next buyer be more likely to want to buy the whole business (and not have to worry about minority shareholders disrupting their plans for change), but a tag along clause gives minorities a sense that they are being treated fairly, and thus less resistant to changes in business direction or sale. Including such a term can align the interests of the founders and the professional investor towards rapid growth followed by near term sale.