Venture-stage investors make their investment in the people of a business as much as they do the idea and the operations. The drive, the know-how, the effort, and the vision of the founders are typically what attract first investment. However, what happens when the founder then leaves either by their own decision or at the request of the shareholders of the business?

Founders leave the business they started on many occasions and for many reasons. They may have decided that the journey is not for them and want to pursue other paths. They may decide they have put in years of work and have other life circumstances. They may decide they like the adventure of the start-up but not the different challenges of scaling and growing at a new pace. In more challenging circumstances, they may even be asked to leave involuntarily.

This departure creates several questions. How does the business protect the value it created for the investors in it when key personnel can walk out the door? What happens if those personnel decide to compete against the business? 

The market expectations between the U.S. and the UK when it comes to founder exits are perhaps as different as it gets. The U.S. tends to rely more heavily on a “carrot” approach to motivate founders and thus tends to place far fewer restrictions on their post-employment activities. By contrast, the UK often relies more on a “stick” approach, imposing restrictions on competition upon departure and clawing back equity in some cases. In this article, we consider how and why the two markets differ on the topic of non-competition restrictions.

How are restrictive covenants applied?

Restrictive covenants can be applied typically in two ways: included in governing corporate documents tied to an investment and included in employment arrangements directly. The means of implementation will often influence enforceability.

How are corporate restrictive covenants applied?

Both the U.S. and the UK generally have strong support in the law for restrictive covenants included in a corporate transaction document in connection with the sale of a business. They are largely more enforceable where the parties are deemed to have more equal bargaining power. The highest probability of enforceability is in the context of a sale of a business under a share or asset purchase agreement, on the basis that a purchaser has intrinsically placed a value on the goodwill, reputation, and commercial operations of a business and it is therefore in their legitimate business interests to protect it. However, most jurisdictions in the U.S. tend to be more limiting on the use of such restrictions with minority investments. By contrast, the UK does permit restrictive covenants more readily in minority investments.

Restrictive covenants in corporate transactional agreements are often enforceable for longer periods than simple employment arrangements and tend to have much more protection. For example, it is not unusual for founders and key executives who are selling shareholders to agree to restrictive covenants of between six months and two years following a sale in the UK or up to four or five years in the U.S. By contrast, both jurisdictions generally allow a much shorter period (if any) in employment arrangements.

What is the general position regarding employment restrictive covenants in the UK and U.S.?

The use of post-termination restrictive covenants (i.e., non-competes and customer/employee non-solicits for certain duration following the end of employment) to protect business interests is an established legal tool in many jurisdictions. While frequently used in connection with the sale of a business, the use of these provisions in investments varies between the U.S. and the UK. 

In the UK, it is common for domestic venture investors to seek to impose restrictive covenants on founders and key executives in both shareholders’ agreements and their service agreements. In fact, the BVCA model documents include a set of restrictive covenants that are increasingly viewed as the norm in the UK market. 

By contrast, the U.S. NVCA model documents, which are even more ubiquitous in U.S. deals than the British Private Equity and Venture Capital Association forms, do not include restrictive covenants at all. U.S. investors generally do not expect such provisions. Thus, it is therefore not uncommon for U.S. venture capital firms investing in UK companies to be willing to accept a shorter post-termination period for these restrictions on UK deals, and in some cases none at all.

Why the difference between U.S. and UK practice?

As a general matter, employment is much more flexible in the U.S. Most jurisdictions and employees are “at-will,” meaning there is little statutory protection as to termination and often any severance payment is only what is contractually negotiated. Absent discrimination claims and the reputational effects on recruiting that comes with aggressive termination practices, most U.S. employers have extensive ability to terminate employment quickly and with little payment to the employee. Given that flexibility to fire employees more easily, the U.S. market also tends not to expect to hold those same employees out of the market.

In comparison, the UK tends to have more restrictions on termination of employment, often mandating guaranteed severance or notice periods of several weeks or months for many employees. However, given the cost of that, many UK investors also expect employees to be restricted in their next move from competing against the company.

How does the law vary?

The U.S.

The current legal position in the U.S. is largely governed at the state level on this topic. However, most of the major venture-focused jurisdictions have more limits on use of non-competition clauses. For example, California—with Silicon Valley at its heart—notably prohibits the use of post-termination restrictions entirely for employees and contractors (excluding those protecting confidential information and trade secrets) on the basis that they are contrary to public policy and goes as far as imposing fines on companies that improperly use them. Other major jurisdictions such as Massachusetts with a large biotech community have not banned such covenants but have imposed limits and requirements on their use.

Even in U.S. jurisdictions where such covenants are permitted, courts will not allow them to survive if the scope of the restriction or duration is overly broad or unreasonable. In such cases, some U.S. states (for example, Texas) will rewrite restrictive covenants to be reasonable, whereas others may permit more limited re-drafting by the court but will not require it. 

Generally, it is becoming harder to enforce restrictive covenants in the U.S. The trend toward banning restrictive covenants entirely is best demonstrated by the U.S. Federal Trade Commission’s (FTC) approval of its Non-Compete Clause Rule, which was first scheduled to come into effect on September 4, 2024. The rule would have invalidated most existing restrictions and applied a ban on non-competes nationwide. However, a federal district court blocked the rule coming into effect. Although the rule is blocked for now, it may not be dead in the water just yet. Just a month before, a federal district court in Pennsylvania declined to block the rule based on findings that directly contradict the Texas federal court’s decision. The FTC filed an appeal against the Texas court’s decision in mid-October 2024, but that appeal process will take some time and, for now, the rule remains blocked. It remains to be seen if the FTC under the new Trump administration will continue to pursue this. Aside from these developments at the federal level, several states have recently moved to restrict the use of non-competes, and we expect that trend to continue. As a result, most U.S. employers in the venture-backed space have already moved to remove non-competes from most of their employment arrangements.

The UK

Contrast this with the UK where such restrictions are still broadly permitted. English courts take the view that restrictive covenants that go further than reasonably necessary to protect a “legitimate business interest” will be void for being in restraint of trade and unenforceable. English courts also generally apply the strict “blue pencil” test, whereby rather than vary or substitute overly broad drafting, the courts will simply strike it out instead. Any remaining parts of the covenant deemed reasonable will then be enforced. However, because of this narrower approach there is a greater risk that a court will simply hold the covenant to be unenforceable altogether. 

In addition, the recent change in the UK government has left commentators wondering if the direction of travel will be similar to the U.S. after the prior Conservative government consulted on potential reforms to limit the use of restrictive covenants in employment contracts but not in share purchase agreements or shareholders’ agreements. The new Labour government did not specifically mention non-competes in its plans for employment law, so it remains to be seen whether the proposals will be implemented. 

How are provisions enforced?

On both sides of the Atlantic, the beneficiary (i.e., the terminating employer) of the restrictive covenants could typically seek an injunction preventing the ex-employer and any new employer from taking action in breach of the restrictive covenants as well as seeking monetary damages. However, taking aggressive enforcement action has reputational implications on future recruiting for companies and investors in a close-knit eco-system like the tech sector.

Is one format better than the other?

It really depends on what you are seeking to optimize. If the goal is more stability of the workforce at the possible cost of innovation and dynamic growth, the UK format is reasonably successful.

By contrast, the more aggressive “win or go home” style of the American venture market thrives with more flexibility in personnel decisions. Restrictions mean that skilled workers would not be able to earn a living or exercise their trade for the benefit of the market as a whole. Would-be entrepreneurs would not be able to launch a new venture that could create jobs, promote entrepreneurship, and advance the relevant sector.

Policymakers on both sides of the Atlantic seem to be increasingly clear that a thriving economy requires individuals to have the freedom to operate; anything beyond what is reasonably necessary business protection is neither good for the individual nor the economy as whole.

Now what?

In Part 2 of this article, we will explore the other major topic in a founder departure: what happens to founder shares when they leave?

For more information on transatlantic companies and non-executive directors, please contact Wilson Sonsini attorneys Martin Luff or Stacy Kim.