It is not uncommon when carrying out due diligence prior to acquisition to find the founders have no restrictions in place. Therefore it is worth ensuring key employees sign up to restrictions prior to investing in a business. In addition, at or around the time of acquisition or investment there can be a period of staff turnover, particularly at the senior end when the future of key individuals with the business may be brought into question. The extent to which the business is protected should there be a senior departure is of paramount importance.
What are the different types of restrictive covenant?
In summary, the most common types of covenant are:
- Non-solicitation: preventing the former employee from approaching clients or prospective clients of the employer with a view to winning their business.
- Non-dealing: this covenant goes further than the non-solicitation covenant and aims to prevent the former employee from providing services to clients or prospective clients – this includes the situation when the customer or client approaches the individual.
- Non- poaching: preventing the former employee from soliciting other employees from their former employer. Non-employment covenants take this concept further and prevent the former employee from employing or facilitating the employment of their former colleagues. Anti-team move clauses seek to prevent a team move.
- Non-compete: prevents an employee joining a competitor employer or setting up a competing business for a set period.
- Garden leave: not technically a restrictive covenant, it is sending an employee home and requiring them not to carry out any business activities, for the employer or anyone else, during the notice period or part of it.
Although garden leave comes at a cost to the employer in paid salary, it is by far the most secure form of limitation on the activities of a departing employee. Garden leave is rarely challenged on legal grounds and the employee is far better controlled as they cannot carry out any activity. Employers can avoid the argument about whether the activity is competing or not.
In addition to the above covenants employers may also seek to require their employees to notify them of offers of employment and to inform any potential future employer of the restrictions to which they are subject. Employers also rely on confidentiality provisions and fiduciary duties to limit potentially damaging activity.
Under the basic principles of contract law it is important for the employer to give valid consideration in order for the restrictive covenants to be enforceable.
Are there limits to the post-employment restriction period and to the geographical area of the restrictive covenants?
Restrictive covenants will only be enforceable if they are no wider than is reasonably necessary to protect the employer’s legitimate commercial interests. If they are too wide they will not be enforceable. It is therefore important that restrictive covenants are focused on the potential business risk and are measured and reasonable in their extent taking account of all the circumstances.
Length and scope of restriction
With the exception of confidentiality, post-termination restrictions must be time bound. When considering what length of time would be reasonable the primary consideration is whether the duration is no longer than is necessary to protect the employer's legitimate business interests. A multitude of factors are taken into account, such as:
- How long would it take to replace the employee?
- How senior is the individual and how much exposure has the employee had to clients?
- What is the industry standard? What is the longevity of the relationships?
- What is the scope of the restriction?
Restrictions should be linked to clients, prospects and employees with whom the employee has had material recent dealings.
The current trend is for restrictions to last for three to twelve months depending on the industry involved. It is also necessary to factor in the ability to place the individual on garden leave and ensure that the overall length of the restrictive covenant is reduced by any period spent on garden leave during the notice period.
Geographical limits
Limiting activity on a geographical basis prevents the former employee from carrying out activities in a specified area. The greater the area, the less likely that the restriction will be enforceable. With technological advances and reduced reliance on physical presence many employers work both nationally and globally, reducing the usefulness, and therefore the use, of geographical restrictions. However, where an employer is seeking to limit an employee's activities geographically they will need to demonstrate that they have a legitimate business interest to protect and that the covenant is no wider than is reasonably necessary.
What remedies are available to the employer when an employee breaches their restrictions?
Employers often seek injunctions to restrict the former employee. Prohibitory injunctions are the most common form of injunctive relief in restrictive covenant cases. The order prevents the former employee from doing a certain activity – such as soliciting clients. Injunctions may be granted on either an interim basis or a final basis. Interim injunctions are granted on a short-term basis until the dispute can be fully considered in court, whereas injunctions granted on a final basis are considered to be permanent.
Employers also frequently request undertakings (binding promises) from the employee to refrain from breaching the contractual restrictions pending the outcome of the court proceedings.
Employers may also seek damages relating to the loss suffered by the employer in consequence of the former employee's unlawful activity.
Applications for injunctions are particularly intensive and expensive.
Interaction of restrictions in the employment contract and the share purchase agreement
The sellers of shares will often be key employees within the business. We are frequently asked whether the restrictions in an employment agreement can mirror the restrictions in a share purchase agreement or in a shareholders' agreement. The short answer to this is no (unless the restrictions in the share purchase agreement or the shareholders' agreement are relatively short in length). The reason for this is because the individual essentially has two 'hats' on – one of shareholder and one of employee. When the individual is acting in their shareholder capacity, it is seen as more of a business to business transaction, in which the buyer is protecting the goodwill of the business they have acquired often for considerable sums, and therefore an individual can be restricted for a much longer period than you would be able to restrict an employee for.
By contrast, when the individual is acting in their employee capacity, there is a perceived inequality of bargaining position and therefore you will only be able to restrict an employee for a shorter period (current trend three to twelve months depending on the circumstances as set out above). Covenants that continuing employee shareholders give in a shareholders' agreement sit in the middle ground on the sliding scale between business sellers and lowly employees: where they sit depends on issues such as the value of their shareholding and whether they are experienced senior executives or rank and file employees. So you may want to have different classes of shares for employees in different categories, with differential covenants applying. Where you see good well drafted, enforceable restrictive covenants in the employment contract we often also see shareholders' agreement covenants being even more robust.
Another point which differs between restrictions in an employment contract and a share purchase agreement is when they 'kick in'. Restrictions in a share purchase agreement typically restrict from the point the deal completes however, restrictions in an employment contract won't kick in until the employment is terminated.
Reform
Following a government consultation it has been confirmed that a statutory cap of three months on non-compete clauses in employment contracts (but not other forms of covenant and not shareholder covenants) will be introduced "when Parliamentary time allows". It looks unlikely that this will be before the next election (not least because it was not mentioned in the King's Speech) but it is not known whether any future Labour government is also supportive. If this legislation is enacted, existing employee non-competes will need to be renegotiated.
Conclusion
A departing employee can cause significant harm to a business. Restrictions can help create stability by ensuring the business is suitably protected against such harm. Having bespoke, robustly drafted restrictions which are reviewed regularly and revisited on any promotion is crucial and should be a key requirement for anyone looking to buy or invest in a business. If an employer gets the drafting wrong the restrictive covenant can be found to be void and the employer can be left with no protection. Taking legal advice and erring on the side of caution is a sensible approach when it comes to drafting restrictions.
DWF has a market leading venture and growth capital practice in the UK, supporting investors and companies across several sectors including financial services, technology, media and telecommunications, life sciences and healthcare and real estate and infrastructure.
If you have queries on any of the issues covered in this article please contact one of our experts.
