Restrictive Covenants in Shareholder Agreements

Restrictive covenants are commonly included in employment contracts, but they can also appear in consultancy agreements, partnership agreements, directors’ service agreements and other commercial contracts. They may also be contained in a standalone agreement.

Shareholder agreements frequently include restrictive covenants designed to protect the company’s goodwill, confidential information and commercial interests. Although restrictions in shareholder agreements may be more readily justified than those in employment contracts, they must still be reasonable and go no further than necessary to protect legitimate business interests. Enforceability depends on the wording and circumstances of the agreement.

Types of Restrictive Covenants

Common restrictions include:

• Non-compete covenants – Prevent shareholders from establishing, joining or participating in a competing business during their shareholding or for a specified period after leaving. These provisions aim to protect the company’s market position and commercial opportunities.
• Non-solicitation of customers or suppliers – Restrict a shareholder from approaching or enticing away the company’s customers, clients or suppliers, helping to protect established commercial relationships.
• Non-solicitation of employees – Restrict shareholders from recruiting or attempting to entice away the company’s employees, helping to protect workforce stability.
• Non-dealing restrictions – Go beyond non-solicitation by restricting a departing shareholder from dealing with specified clients or suppliers, even where there has been no active solicitation.
• Confidentiality obligations – Require shareholders to protect sensitive business information, trade secrets and know-how during their involvement with the company and, where appropriate, after their departure.
• Intellectual property protections – Help ensure that intellectual property created for the business is properly owned by the company and cannot be exploited independently without authorisation.

Restrictions lasting two to three years may be appropriate in some shareholder agreements, depending on the circumstances. There is no automatic rule that this duration is enforceable: the scope and duration of each restriction must be justified.

Enforcement of Restrictive Covenants in Shareholder Agreements

Even where a restrictive covenant appears valid, enforcement depends on its enforceability, the available remedies and the evidence supporting the claim.

A common remedy is an injunction to prevent or restrain a breach, such as competing in breach of a valid restriction, soliciting clients or misusing confidential information. Whether an injunction is granted depends on the applicable legal test and the circumstances of the case.

A company may also claim damages for losses caused by a breach. Quantifying those losses can be complex, particularly when establishing which clients were diverted or what profits were lost. A breach may also affect the value of the company, although any claim for damages must be properly evidenced and assessed in accordance with the applicable legal principles.

Some shareholder agreements include contractual remedies, such as compulsory share transfer provisions. For example, a shareholder who breaches specified obligations may be required to transfer their shares, potentially at a discounted price. The validity and operation of such provisions depend on their drafting, the circumstances of the breach and the applicable law.

Conclusions

From an employee-shareholder’s perspective, it is important to review restrictive covenants in both the shareholders’ agreement and the employment contract. The restrictions may differ between the agreements and have different implications for the individual and the business.

Gannons can help business owners and shareholders review, draft and negotiate restrictive covenants to protect legitimate business interests and reduce the risk of disputes.

Please do call us on 0207 438 1060 to discuss how we can help.