Restrictive Covenants in Shareholder Agreements

While restrictive covenants are usually a feature of an employment contract, they can also appear in consultancy agreements, partnership agreements, directors’ service agreements and other similar contracts. They can also be introduced in a separate agreement all of their own (usually).

Shareholder agreements frequently include restrictive covenants designed to protect the company’s goodwill, confidential information, and commercial stability. Unlike employment contracts, where courts apply a strict test of enforceability, restrictions in shareholder agreements are generally given greater latitude because shareholders typically have stronger bargaining power and a direct financial stake in the business.

Types of Restrictive Covenants

Common restrictions include:

• Non-compete covenants - Prevent shareholders from setting up or participating in a competing business during their shareholding and for a specified period after exit. These provisions help safeguard the company’s market position and future opportunities.
• Non-solicitation of customers or suppliers - Restricts a shareholder from approaching or enticing away the company’s customers, clients, or suppliers. This ensures that commercial relationships developed by the company remain protected.
• Non-solicitation of employees - Prevents shareholders from recruiting or attempting to poach the company’s staff, thereby maintaining workforce stability and protecting against disruption.
• Non-dealing restrictions - Goes further than non-solicitation by prohibiting a departing shareholder from dealing with clients or suppliers altogether, even where there has been no active solicitation.
• Confidentiality obligations - Requires shareholders to maintain the confidentiality of sensitive information, trade secrets, and know-how obtained during their involvement with the company, both while they are shareholders and after their exit.
• Intellectual property protections - Ensures that any IP created in the course of the shareholder’s involvement belongs to the company and cannot be exploited independently.

In a shareholder context, restrictions of 2–3 years may be justifiable, unlike the shorter periods usually permitted in employment contracts.

Enforcement of Restrictive Covenants in Shareholder Agreements

Even if a restrictive covenant is valid on its face, enforcement depends on the remedies available and the evidential burden in court.

The most common remedy is an injunction to prevent a shareholder from breaching the covenant (e.g. competing, soliciting clients, or misusing confidential information).

In addition to, or instead of, an injunction, a company may claim damages for losses suffered. In practice, quantifying loss (e.g. how many clients were diverted, or the value of business lost) can be complex. For shareholders, because they typically hold a financial stake in the business, breaches can often be linked to a measurable reduction in company value or loss of profits, which may make damages more readily calculable than in an employment setting.

Some shareholder agreements include contractual remedies such as compulsory transfer provisions. For example, a breaching shareholder may be required to sell their shares (often at a discount) if they breach restrictive covenants..

Conclusions

From an employee shareholder’s perspective, the search for restrictive covenants should encompass the shareholders’ agreement as well as the employment contract. This is something which Gannons would be happy to assist you with.

Please do call us on 0207 438 1060 for help.