This post is the seventeenth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.
In the prior sixteen posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions and discussed valuation, cap tables, and the price per share, dividends on preferred stock, liquidation preferences, the conversion rights and features of preferred stock, voting rights and investor protection provisions, anti-dilution provisions, anti-dilution carve-outs and “pay to play” provisions, redemption rights, registration rights, management and information rights, preemptive rights, drag-along rights, representations and warranties, rights of first refusal and co-sale, and closing conditions and expenses. In this post, we will discuss non-competition and non-solicitation agreements.
The NVCA model term sheet (available here) provides that each founder and key employee will enter into a non-competition agreement and non-solicitation agreement. The non-competition provisions will restrict the founders and key employees from competition with the company while they are employed and for a specified time thereafter (usually one to two years) and within a specified geographical area (which could be the entire United States or beyond, if the company’s business is national or international). The non-solicitation provisions will restrict the founders and key employees from soliciting the company’s existing (and perhaps potential) customers and employees.
While covenants not to compete and solicit customers and employees are common in employment generally and also in connection with venture capital transactions, their enforceability depends on the state law governing the agreement (which the parties will select, and is often the state law governing the other transaction documents). Some states look with disfavor upon such agreements, especially when not in the context of a business sale. Some states require that such agreements be supported by some type of consideration — something the employee gets out of it — which might not be satisfied by the company’s mere continuation of the employee’s employment.
Founders of companies receiving venture funding should expect to be presented with non-competition and non-solicitation agreements, but they should not be dismissed as extra paper for the deal. They can come back to haunt the founder if the founder and the company part ways down the line, and should be carefully reviewed and various future scenarios considered. Founders should make sure that they key terms (scope of the “competitive activity” restricted, the geographic area, and the term) are as narrowly drawn as possible. In some circumstances, founders might also ask for additional compensation in exchange for entering into the agreements.
In the next post, we’ll discuss non-disclosure and developments agreements.
© 2014 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.