Litigators are often accused of having 20/20 hindsight but sadly a lot of our work involves the aftermath of deals and business relationships that have gone wrong. After a while you see points that repeat themselves and find yourself saying, “if only they’d done …..” (again). A really good example of this is the use of restrictive covenants between founders at the outset of a venture, whether that be for a completely new business or perhaps one to be conducted through a joint venture, and their use as a business matures, particularly if you’re thinking about exit strategies.
Restrictive covenants are usually thought about in an employment context as a device to stop rogue employees in their tracks if they leave but they play an equally important role at partner/shareholder level in terms of protecting value. A couple of case studies illustrate the issues well.
The Working Shareholder
Z was an executive director and minority shareholder in a trading business. She performed well and built up her customer-facing role to the point where she became the face of the company for the vast majority of its customers.
Z’s other shareholders decided they wanted to sell. Z was the obvious candidate to buy them out and was very interested but they couldn’t agree a price. Relationships between the shareholders soured and invigorated by the thought of running her own show, Z decided to resign as a director to do her own thing. With no employment contract or shareholders’ agreement containing a restrictive covenant, and having been careful not to do anything that might have breached her director’s duties in relation to her new venture before she left, she was free to compete directly and intended to do so.
The other shareholders managed to find a buyer prepared to pay a decent price for the company, including Z’s share of it, but on learning that Z was going and would be competing, the buyer pulled out.
A properly drawn covenant probably wouldn’t have stopped Z’s departure but it would perhaps have saved the sale because the lost buyer would have known they had a free run without interference from Z for the length of the restriction. Without it they simply weren’t prepared to take the risk of competing in the market.
The sad thing about the whole case was that it turned out to be a lose/lose scenario. Z really needed to turn her shareholding into cash to fund her new venture. Without that money she had to launch a business that was a far cry from what it could have been with more funding. In the field in question a covenant would only really have been enforceable if it had a relatively short duration and ironically Z could have used some of the cash to tide her over while that period expired.
A covenant in this case would have protected the value in the original business for the benefit of all of its shareholders and given all of them a worthwhile exit.
I’ll admit Z’s story is unique and that it’s unusual for a covenant to have the potential to help remaining and departing shareholders, but at the same time, as the old saying goes, sometimes the exception proves the rule.
The Unhappy Seller
B’s story also involves the sale of a business. He’d built up a successful consultancy and sold it for a decent price. So far so good, but enter his two years of deferred consideration stage left 12 months down the line. So far so good. But 12 months down the line there was still another year of deferred consideration to worry about.
As part of the sale and purchase agreement B had agreed not to compete with the business he’d sold. The new owners benefitted from this, did well and retained quite a few of big trophy clients. They also added a number of new ones, but B’s deferred consideration was dependent on revenue from the old client list, most of whom walked when C, a senior manager, left and took the clients with him.
C wasn’t under covenant so there was nothing the buyers could do about his move. They could, and did, however, challenge the amount of deferred consideration asked for by B. This led to a protracted and costly dispute that saw B having to accept that he’d lost out on six figures worth of consideration. This could have been saved if C had been subject to some sensible restrictions.
Many employers believe they can rely on an employee’s duties of fidelity to control them. These duties certainly have their uses but they are limited and only cover the period during which the employee is employed. Additionally, most departing employees are sensible enough not to breach their duties and in practice they’re no substitute for a decent restrictive covenant.
If you’ve read this far you may well be thinking, OK, all well and good, but these restrictions aren’t worth the paper they’re written on. More hindsight, but in some cases you’d be right because businesses often go for a one size fits all/copy and paste from an old employment contract approach. Do that and the chances are you may not have a leg to stand on if you need to enforce. However properly drafted restrictive covenants do deliver and give real protection to business owners. They don’t need to cost much to get in place and the return on investment they can deliver in both financial and commercial terms can be spectacular.