Should investor sleep with the enemy?
Kristian Holte | email@example.com
In Danish start-up financings, investor often insists that the founders take on non-compete clauses.
In essence, a non-compete means that a founder cannot start a competing business for a period of time if the founder leaves the company. Under Danish law, unlike in California, non-compete clauses are generally valid.
Usually, founders don’t have a lot of trouble accepting to take on non-competes.
At an early stage, few founders can image a future scenario where they are not a part of the company. With good reason. Founders have to narrow their vision to build something unique from scratch.
Despite this, some founders choose to challenge the non-compete in one way or the other.
Usually, investor counters with a variation of the following:
“If you want to start another competing business later anyway, why should I give you my money for this business now?”
“To keep it simple” or to “keep legal costs down” you might respond.
None of these reasons are truly compelling.
Moreover, they often disguise hidden motives. Maybe a founder has doubts that the company will succeed. Maybe a founder doubts the commitment of a co-founder. Of course expressing such a view would be fatal. As a consequence most founders accept the non-compete.
Quite a few end up doing so unwillingly.
Aided by a sense of bitterness, the question then arises whether investor should also take on a non-compete since founders have done so. This ties into a powerful negotiation dynamic: when one side has accepted to take on an obligation against that side’s wishes, good reasons should exist for the other side not to do the same.
A non-compete on part of investor means that investor is not allowed to invest in competitors. Piece of cake, investor takes on the non-compete right and we move on, right?
Not so fast.
From investor’s point of view the non-compete looks very different than from the view of the founders. Some investors are simply afraid of missing out on future lucrative investment opportunities. Other investors have a sector specific investment strategy and per definition cannot accept threats to this strategy inevitable caused by a non-compete.
So who gets their way?
Ultimately, it comes down to bargaining power.
If the founders have multiple term sheets from investors, founders may simply insist on the non-compete as a dealbreaker. However, oftentimes this is not the case. Even if it is, founders may have a particular interest in a given investor despite multiple offers from others.
Tools for negotiating investor’s non-compete:
So what are the ways that founders and investor can resolve disagreement over investor’s non-compete?
Over the years I’ve developed a substantial number of ways. Here are a couple which can be combined creatively to an indefinite extent:
A. Non-compete covering a couple of named competitors
This solution creates a secure position for both sides since it is very clear which companies investor cannot invest in. The solution may quite the founders’ most eminent fears, particularly if founders’ company has a few distinct competitors.
On the other hand, investor is free to invest in all other companies. If investor rejects this solution, the burden is on investor to explain the reasons that investor wants to preserve the possibility of investing in those exact companies.
B. Non-compete that defines the market very narrowly
This solution gives investor more leeway that the above solution A. Still, the market is defined narrowly which is meant to preclude as few companies as possible investment targets for investor.
C. Non-compete for a limited period of time
Sometimes the solution can be that investor takes on a non-compete for a limited period of time. This period could for example be 12 months from the time of the investment. In this way, the founders know for sure that investor won’t invest in any competitors within this timeframe.
How about afterwards? Well, then … the handcuffs are off.
D. No non-compete, but investor turns into a passive one
A brilliant colleague of mine originally proposed this solution to me when we discussed the issue. I’ve since used it on several occasions in negotiations. In essence, investor does not take on a non-compete. However, if investor chooses to invest in a competitor, investor losses all control over the founders’ company.
This means that investor’s shares are converted to voteless shares, investor looses status as board member and any veto rights or other control rights are lost. This solution might be suitable for founders that care deeply about the issue and posses significant bargaining power.
E. No non-compete combined with a hefty fine
For most founders fear that investor shares confidential knowledge about their company with a competitor. The thought alone hurts a lot.
A solution could be to leave out a non-compete all together. Instead, investor takes on a duty of confidentiality. This means that investor cannot share certain information with the outside world. If investor does so anyway, investor would have to pay a hefty fine and in addition sell back investor’s shares at a low price.
This solution works fine in theory and may to a certain extent create the right incentives. The problem is, however, that it is often very hard to prove that somebody has breached a duty of confidentiality unless somebody trustworthy is willing to testify or if investor mistakenly has put the breach in writing.
In the end, the question remains: should investor sleep with the enemy?
Authored by Kristian Holte, start-up lawyer | firstname.lastname@example.org