How startups enforce non-competition of departing co-founders

By Leo Yu and Alicia Wu, Jingtian & Gongcheng
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It is self-evident that co-founders are of vital importance to startups, however, during the development of the company, they often leave for various reasons. Co-founders of startups are intimately familiar with their company’s core technology or trade secrets, so when they opt to leave, their departure is always a most undesirable scenario. That’s especially so if they go on to work with any competitor – which can severely damage the original company’s interests and business development. On top of that, any mishandling of non-competition issues could hamper a company’s financing or listing prospects.

This article introduces two key approaches to enforcing non-competition with regard to departing co-founders, with the ultimate purpose of safeguarding the company’s trade secrets and intellectual property, and maintaining its competitive edge.

Non-competition obligations may be established through either financing or equity transfer agreements, or through non-competition clauses in agreements that the co-founders sign as employees of the company.

EQUITY HOLDING

For co-founders directly or indirectly holding the startups’ equity, companies may specify non-competition within a certain time frame in the shareholding agreements that co-founders sign when they set up the company or when receiving options. If non-competition has been omitted in this step, companies should try to establish non-competition obligations via equity agreements at the time of their departure or equity repurchase. Currently,

喻鑫, Leo Yu, Partner, Jingtian & Gongcheng.
Leo Yu
Partner
Jingtian & Gongcheng

We recommend companies buy back equity held by co-founders when they leave, but we are also aware of cases where co-founders are allowed to retain their equity on the condition that they uphold their non-competition obligations. In such cases, the obligation often extends for two or three more years after the co-founder no longer holds the equity.

For equity transfer agreements, courts typically do not order the company to pay any additional consideration to the co-founder for non-competition. To be on the safe side, we believe that if actual controllers or investors are expected to pay a high price to repurchase co-founders’ equity, the proper fulfillment of non-competition obligations should be highlighted in the agreement as a condition precedent for such a payment. This may give the company a better chance that the court will recognise a more extended period of non-competition.

LABOUR RELATIONS

According to the Labour Contract Law, an employer may enter into agreements with three types of personnel (i.e. senior management, senior technical staff and others with confidentiality obligations) containing clauses that bar them from starting or engaging in any business deemed to compete with itself within two years after leaving office. If companies opt to activate such non-competition clauses when co-founders depart, it should be sufficient to restrict any competition.

吴悦-ALICIA-WU-竞天公诚律师事务所律师-Associate-Jingtian-&-Gongcheng
Alicia Wu
Associate
Jingtian & Gongcheng

Often, co-founders do not directly hold founders’ shares in a startup, but instead receive equity under the company’s incentive schemes while serving in senior management positions. Such equity was vested with the co-founders based on his/her labour relation with the company and upon satisfying specific performance-appraisal indicators.

Therefore, apart from non-competition agreements or clauses, the liability for breaching non-competition obligations may be linked with the co-founder’s incentive equity. If the co-founder departs while holding any onshore or offshore equity-based incentives granted or vested under the company’s incentive scheme, the company may link the non-competition agreement with these schemes, so a breach of the former would simultaneously trigger a breach of the latter. Heftier consequences would encourage co-founders to uphold their obligations. As an alternative to seeking damages, companies may also arrange to reclaim a breaching co-founder’s incentive equity; or, if the co-founder has traded his/her equity on the open market, the amount equating to his/her total proceeds.

In summary, startups may enforce the non-competition of co-founders through either equity holding or labour relations. If non-competition clauses have been properly set out under the equity agreements, it makes sense that enforcing non-competition through these clauses should be the startups’ first option. Where the non-competition obligations were not expressly or adequately addressed under the equity agreements, the non-competition agreements signed by the co-founders when they join the company as employees can be used as a safety net. Companies can also strive for more favourable non-competition arrangements when negotiating to repurchase the equity. Given that, in the event of a breach, the co-founder could be held accountable on both fronts, it makes sense for companies to pursue both angles to cover all bases.

Leo Yu is a partner and Alicia Wu is an associate at Jingtian & Gongcheng

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