Why Non-Compete Clauses Belong in Shareholder Agreements
A shareholder who simultaneously operates or invests in a competing business can cause serious damage. They have access to confidential information, trade secrets, customer relationships, and strategic plans. Without a non-compete clause, nothing prevents them from using that knowledge to build a rival business or divert opportunities away from the company.
Non-compete clauses in shareholder agreements protect the company and all shareholders by ensuring that no shareholder undermines the business from within. They are distinct from employment-based non-competes because they are tied to equity ownership rather than an employment relationship, which often makes them easier to enforce.
Key Elements of a Shareholder Non-Compete
Scope of Restricted Activities
The non-compete should clearly define what activities are prohibited. Vague restrictions like "shall not compete" invite disputes about what constitutes competition. Specific language is better:
- Direct competition — owning, operating, or managing a business that offers the same products or services
- Employment with competitors — working as an employee, consultant, or advisor for a competing business
- Solicitation of customers — approaching the company's customers to divert business
- Solicitation of employees — recruiting the company's employees for a competing venture
- Diversion of opportunities — pursuing business opportunities that rightfully belong to the company
Each of these restrictions serves a different purpose and may have different enforceability considerations.
Geographic Scope
The geographic scope should be reasonable and related to the company's actual market. A nationwide restriction may be appropriate for an e-commerce company that sells across the country, but it would be excessive for a local restaurant.
Common approaches include:
- Specific radius — within 50 miles of the company's offices or operating locations
- Named territories — specific states, regions, or countries where the company operates
- Market-based — wherever the company has customers or actively markets its services
- No geographic limitation — appropriate for online businesses with no physical boundaries
Duration
The restriction period typically applies during the shareholder's ownership and for a specified period after they cease to be a shareholder. Common post-ownership restriction periods range from 12 to 24 months.
During ownership: The restriction applies as long as the person holds shares. This is generally the easiest part to enforce because the shareholder has a fiduciary duty to the company.
Post-ownership: The restriction continues for a defined period after the shareholder sells or forfeits their shares. Courts scrutinize post-ownership restrictions more carefully and are less likely to enforce unreasonably long periods.
Keep the post-ownership restriction period reasonable — 12 to 24 months is the standard. Courts are much more likely to enforce a 12-month restriction than a 5-year one, and a shorter period may actually provide more practical protection because it is more likely to be upheld if challenged.
Consideration
For a non-compete to be enforceable, it must be supported by consideration — something of value exchanged for the restriction. In a shareholder agreement, the consideration is typically:
- The shares themselves (for restrictions imposed at the time of share issuance)
- The shareholder agreement as a whole (the non-compete is part of a broader package of mutual obligations)
- A buyout payment (for restrictions that take effect upon departure)
Carve-Outs and Exceptions
A well-drafted non-compete includes exceptions for activities that do not pose a genuine competitive threat:
Passive Investments
Shareholders should be permitted to hold passive investments in competing companies, provided the investment is small enough that it does not give them influence or access to competitive information. A common threshold is ownership of less than 5% of a publicly traded competitor's stock.
Pre-Existing Activities
If a shareholder had an existing business or investment before joining the company, the non-compete should include a carve-out for continuing that activity. The specific pre-existing activities should be listed in a schedule attached to the agreement.
Unrelated Businesses
The non-compete should only restrict activities that compete with the company's actual business. A founder of a software company should not be prevented from owning a restaurant, for example. Define the company's business narrowly enough that the restriction does not prevent shareholders from pursuing unrelated opportunities.
Post-Termination Employment
Consider whether the non-compete should restrict a departing shareholder from taking any position with a competitor or only positions that could enable the use of the company's confidential information. A narrow restriction focused on competitive roles is more likely to be enforceable than a blanket prohibition on working for any competitor in any capacity.
Non-Solicitation Provisions
Non-solicitation clauses are closely related to non-competes and are often included alongside them.
Customer Non-Solicitation
Prohibits shareholders from soliciting the company's customers to divert business to a competing venture. This should specify:
- Which customers are covered (all customers, or only those the shareholder had direct contact with)
- What constitutes solicitation (actively reaching out vs passively accepting business)
- How long the restriction lasts after departure
Employee Non-Solicitation
Prohibits shareholders from recruiting the company's employees for a competing business. This prevents a departing shareholder from gutting the company's talent pool.
Non-solicitation clauses are generally easier to enforce than non-competes because they are narrower in scope. Even in jurisdictions that limit non-compete enforceability, courts often uphold reasonable non-solicitation restrictions.
Enforceability Considerations
Reasonableness
Courts evaluate non-competes based on reasonableness. A restriction is more likely to be enforceable if it is:
- Narrow in scope — limited to activities that genuinely compete with the company
- Limited in geography — restricted to areas where the company actually operates
- Limited in duration — 12 to 24 months post-departure is generally considered reasonable
- Supported by a legitimate business interest — protecting trade secrets, customer relationships, or specialized training
- Not unduly burdensome — does not prevent the shareholder from earning a livelihood
Jurisdiction-Specific Rules
Non-compete enforceability varies significantly by jurisdiction:
- Some states strongly enforce reasonable non-competes in shareholder agreements
- California generally prohibits non-competes for employees but has been more receptive to restrictions tied to the sale of a business or equity interest
- Other jurisdictions may have specific statutes governing non-compete agreements, including requirements for minimum duration thresholds or garden leave payments
Always consider the applicable jurisdiction when drafting non-compete provisions. The shareholder agreement should specify which jurisdiction's law governs the non-compete clause.
Blue Pencil Doctrine
Some jurisdictions allow courts to modify (or "blue pencil") an overbroad non-compete to make it reasonable and enforceable, rather than striking it entirely. Include a provision in the agreement inviting the court to reform the restriction if it is found to be overly broad. This preserves some protection even if the original language goes too far.
Remedies for Breach
Injunctive Relief
The most effective remedy for a non-compete violation is an injunction — a court order requiring the violating shareholder to stop the competing activity immediately. The agreement should include a provision acknowledging that a breach would cause irreparable harm and that injunctive relief is an appropriate remedy, without the need to prove monetary damages.
Damages
In addition to injunctive relief, the company and other shareholders may seek monetary damages for losses caused by the breach. However, proving damages from a non-compete violation can be difficult, which is why injunctive relief is typically the primary remedy.
Forfeiture of Shares or Payments
The agreement can provide that a shareholder who breaches the non-compete forfeits certain rights, such as:
- Unvested shares
- Outstanding buyout payments
- Earn-out payments
- The right to exercise preemptive or tag-along rights
Liquidated Damages
If monetary damages would be difficult to prove, the agreement can include a liquidated damages provision specifying a predetermined amount that the breaching shareholder must pay. The amount must be a reasonable estimate of the actual damages likely to result from a breach.
Best Practices
- Be specific about restricted activities — vague language invites disputes and may not be enforced
- Match the scope to the actual risk — restrict only activities that genuinely threaten the company
- Include reasonable carve-outs — passive investments, pre-existing activities, and unrelated businesses
- Keep the duration reasonable — 12 to 24 months post-departure is the standard
- Specify remedies — injunctive relief, damages, and forfeiture provisions
- Consider the jurisdiction — draft with the applicable law in mind
- Get independent advice for each shareholder — each party should understand their obligations before signing
Non-compete obligations are a critical component of shareholder agreements that protect the company's competitive position and ensure that all shareholders are working toward the same goal.