“Thou shalt not compete with SaaSco”
So sayeth the venture investor.
Not quite the 11th commandment, but a fair position for venture investors to take. So what does compete look like, and how in practice are these clauses drafted in the director’s service arrangements?
Most importantly for VCs – can investors make these clauses stick?
Standard practice – and why
In all but a very informal, maybe friends and family-type investment round, someone is likely to suggest that the founder team sign employment or service contracts. These are likely to have some form of anti-compete clauses. By the time SaaSco has grown up a bit, and takes onboard some institutional investment, the service contract is pretty much mandatory, and might have expanded by a few pages. The basic principles should still be much the same.
The main principle is the need to protect SaaSco’s business, including its goodwill and intellectual property and is almost axiomatic: if we just took a leap of faith in backing a founder team and a plan with a £1m cheque, it’s a given that they’ll use all their efforts to make the startup succeed. In particular, and this is the crux of the anti-compete clauses, the founders can’t be allowed in any way to undermine SaaSco by feathering their own nest.
So what aspects of competition does a vanilla service contract cover?
Interaction of investment agreements and service contracts
Firstly, a seemingly dull but desperately important legal point[1]. The anti-compete clauses are repeated in substantially the same form in both service contracts (the agreements between the company and each founder) and the investment agreements (between the company, founders and investors). The reason they’re repeated is that the clauses in the investment agreements have far more force.
Employment relationships per se tend to be interpreted in favour of the employee – they’re (kind-of) the weaker party, even if they’re the founder-CEO and owner of 60% of the equity. So SaaSco might well struggle to make a claim stick against a rogue founder if the only protections arose from the employment relationship (occasionally, a very stupid employee gets nailed because they incorporated SaaSco2 in their own name, at the same time as still being employed by SaaSco, and emailed the source code and customer lists to their personal email account, but it seems you have to try pretty hard to get caught out[2]).
Investment agreements on the other hand seem to be interpreted in a more equitable fashion. Maybe it’s that the courts consider both sides as equally savvy business-people, not as employer and vulnerable underling. Partly, also, it’s because the investor has just paid away a big chunk of cash, so there’s no question that they’ve parted with valuable consideration, and can expect something (like honesty) in return. So the investment agreement prohibition on competition is more likely to be enforced than exactly the same clause in the service contract.
For the same reason, the courts seem less likely to strike down clauses in the investment agreement for being unduly onerous. The lawyers might, for example, get twitchy if the investor wants the service contract to bar a founder from working for the competition for a year after leaving. They might, however, be totally relaxed at a two year prohibition in the investment agreement.
So the take-away from this sub-section is to more-or-less cut and paste the anti-compete provisions from the service contract into the investment agreement, and play around with the variables (like scope) to agree something that’s both fair and enforceable.
What, where, when
There are two aspects to the what. Firstly: the nature of the company’s business, against which the founder cannot compete, and as defined. We sometimes spend quite a bit of time defining what SaaSco does[3]. “An online platform for the analysis and consolidated reporting of retail investors’ holdings of non-fungible tokens” might seem a bit narrow from the company’s and investors’ point of view, especially when SaaSco pivots to D2C vegan dog food subscriptions. Equally, the founders are going to scream at the breadth of a definition that reads digital and retail operations. It perhaps doesn’t matter too much in any case – the definition usually includes something like or such business as is undertaken by the company from time to time. In other words the can is kicked down the line and the company and founder will need to agree or fight it out in years to come.
The other aspect of the what is the actions that amount to competition. The list is usually pretty standard: thou shalt not poach SaaSco’s staff, nor its customers, nor covet its suppliers, nor make unto thee a competing business. The last clause is clearly the most important, the least clearly-defined, and therefore the one most likely to result in disagreement years down the line.
The where is the geographical scope. This used to make sense in years past – think about the FMCG regional sales director with a clear territory outside of which he had no goodwill. For a tech-led start-up or D2C brand, however, it makes no sense. The world’s your oyster. If you’re not in the US yet, your whole plan is to get there at some point, and neither investor nor the rest of the team want a founder to peel-off and get there first with all their hard-earned insights. So our default would be to ask for a total bar, regardless of location.
Lastly, when. The minimum is for the duration of the founder’s employment with SaaSco (they are paying the founder, after all). In addition, the anti-compete clauses need to last for a post-leaving period. Two years is common (in the investment agreement clauses, but less in the service contract). The point in time of leaving might vary – sometimes it’s cessation of employment or directorship, but sometimes its cessation of holding shares. That’s usually longer, and creates a very interesting interaction with the good and bad leaver clauses.
Who’s benefit is this all for?
In passing, it’s worth noting that – like so many of the investor protections we discuss – that the anti-compete clauses don’t just protect the investors. They protect the company. So the founder team in respect of each other, the other shareholders, the rest of the staff, they all benefit from these agreements. It’s just that the first institutional investment is typically the catalyst for a clean-up of all of SaaSco’s governance.
Anti-compete clauses in the real world
The truth is, like so many of the protections we’ve looked at in these posts, we spend a lot of time negotiating the clauses. We worry about them. Founders worry about them. They get negotiated and agreed. They get archived somewhere in Sharepoint hell, and never reappear. That’s the whole point of course – to make sure that we as investors understand and agree how to work together with the founders – not to constantly refer to them to see what each party can get away with. The other issue is that normally there’s a lot of goodwill in the investor–founder relationship so no-one’s pushing the boundaries of the agreements.
Consequently, and thankfully, we don’t have a vast catalogue of war stories. But when a founder goes bad, SaaSco and the remaining founders will be grateful for clear rights on how to deal with the wrong. The worst example – from a human as well as a legal and commercial point of view – was a start-up founder (call him John[4]) who was a lifelong friend of the two other co-founders. Start-up had some bad times in the early days, but broadly met its plan, which is pretty unusual. John went overseas to launch Start-up in new markets. Progress overseas was not stellar, but was ok. And after over a year, the two co-founders discovered that their life-long friend John was running two companies, Start-up GmbH, and John GmbH, splitting the incoming business fairly equally. One-for-me, one-for-you. Start-up lawyered-up, and few months later John was jobless, share-less, and (even worse) without a reference. Or friends. The whole matter might have been escalated legally – fraud for example – but life’s too short, and the anti-compete clauses did the job simply and without much fuss or cost.
I never did find out why John did it. The whole incident was a massive shame.
Round-up
Investors, company, and co-founders alike need to agree tough, clear, and fair anti-compete provisions, and put them into both their service contracts and the investment agreement. Then they’ll probably never see light of day again.
Next post: coming up (roll of drums)…………service contracts and leaver provisions: how they work together.
Partner, DSW Ventures
About DSW Ventures
DSW Ventures made its first investment in 2018 and is an investor in early-stage scale-up businesses requiring venture funding of more than £250,000, primarily on an EIS basis. It is funded by a growing network of high-net-worth investors. DSW Ventures is a trading style of DSW Venture Capital LLP, part of the Dow Schofield Watts Group.
DSW Ventures is a partner in British Business Investments’ £100m Regional Angels Programme, designed to help reduce regional imbalances in access to early stage equity finance for smaller businesses across the UK. British Business Investments is a wholly-owned commercial subsidiary of the British Business Bank, the UK government’s economic development bank.
Dow Schofield Watts is a UK independent advisory and investment group, headquartered in Warrington, Cheshire and with offices in Manchester, Leeds, Aberdeen, and London.
About British Business Investments
British Business Investments is a commercial subsidiary of the British Business Bank. Its role is to increase the overall supply and diversity of finance – both product and provider – on offer to UK smaller businesses. It does this while providing value for money for UK taxpayers. British Business Investments does not finance small businesses directly, but instead works with the market to provide funding through its delivery partners. These partners offer a range of funding options for small and high-growth businesses across sectors, regions and business stages.
[1] We pick up a lot of insights in the course of being venture investors, but we’re not lawyers, so don’t take any of this as legal advice. It could well be wrong. It’s just food for thought. Speak to a lawyer. They know best.
[2] See point 1 but even more so – you really should take legal advice if you plan to steal your company’s trade secrets. And whilst we don’t want to get too prissy, in moral terms it’s often thought to be a bad thing.
[3] What SaaSco does in reality is and will forever remain a mystery, dear reader. It’s even conceivable that we don’t actually know.
[4] He was not really called John. But then you knew that already, didn’t you.