Saturday, December 09, 2006

VC Funding: The Non-Compete Clause

In preparation for the Landmines seminar in January I have been checking my list (and checking it twice) of "VC terms that every investee should question". Near the top is the provision in shareholders agreements that restricts shareholders from working or investing in businesses that are competitive.

Every shareholder but your VCs, that is. Here's how the fine print on these provisions typically reads:

"The parties hereto acknowledges that the [VCs] may from time to time hold investments in corporations (a “Competitive Corporation”) which may be competitive with the Corporation and its business. None of the [VCs] shall have any liability to any of the parties to this Agreement for any claim arising out of or in any way relating to any such investment or any actions taken by any partner, director, officer, employee or other representative (each a “Representative”) of any [VC] to assist a Competitive Corporation (whether as a director of such Competitive Corporation or otherwise) regardless of whether any such action may have a detrimental effect on the Corporation."

In other words, your VC investor: (a) is not bound by any non-compete or non-solicitation restrictions, and (b) may invest in one or more of your competitors, and solicit employees or customers away from you, all without incurring any liability to your shareholders or your company for any breach of fiduciary obligation.

Most VCs will tell you that the intent behind such a provision is an honourable one. Venture capital looks for disruptive technologies and business models to invest in. If a technology or business model is truly disruptive, its market likely does not yet exist. It is therefore possible, a VC may explain, that an investment he/she makes may have started out in an adjacent market, but ended up in your segment. The VC does not wish to be penalized for this development.

I think this position is understandable, and even rational, but ultimately it's not defensible. Here's why: Regardless of what the agreement says, I doubt that most courts would agree that one can contract out of one's fiduciary obligations. Even if this provision were enforceable among shareholders, there are other stakeholders (option holders, employees, creditors, directors) who will not have not signed the shareholders agreement and have not therefore assented to this term. There is still exposure to a VC investor who works with competitors.

A possible solution here would be to require a firewall between fund members who work with one company and those who work with a competitor. Given the small size of most funds, however, this doesn't seem practical, or even possible.

So why agree to the term at all? If your investors are generalists, this may be an acceptable risk to take on. But if your backers include industry focused funds who invest in every place on the value chain for your market segment, this could be a significant problem.

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