An Analysis of the Non-competition Clause in Private Equity Investment Agreements

Author:Rick Wang,Pingping Qiu

Insights

Along with its rapid development, the private equity investment market has become an important force for driving the development of enterprises in China. For most enterprises, the most valuable property is men—men with professional intellectual properties, men with advanced business concepts, men with extensive market resources—who push the enterprises forward to realize leapfrog development. When making investment, private equity investors shall pay enough attention to the target company’s staff to strictly control possible human-induced risks in the company. One of the most important risks is the non-competition risk. The author—in combination with his experience in providing private equity investment-related legal services in the recent years and in the investors’ perspective—here sorts out and analyzes the commonly-seen non-competition clauses in investment agreements for the investors’ reference. 

I. Origin of the Non-competition Duty

Non-competition (“竞业禁止,” a.k.a., “竞业限制” and “竞业回避” in Chinese) refers to the situation where, according to legal provisions or contract provisions, a company’s directors, senior managers and other personnel having the confidentiality duty that are restrained and prohibited from working while in any unit that is in competition agains the company, and are prohibited from engaging in any business that is in competition against the company’s businesses in a certain period after they separate from their posts. In essence, non-competition is a restraining measure taken by an employer against specific staff in order to protect its business secrets. It mainly involves two circumstances: the law-bound non-competition duty and the contract-bound non-competition duty.

1. The law-bound non-competition duty

The legally bound non-competition duty originates from direct legal provisions, and can’t be resolved by agreement. The Company Law, Partnership Law and Regulations for the Implementation of the Law on Chinese-foreign Equity Joint Ventures ofChinaall have relevant non-competition provisions:

Item 5 of Article 148 of the Company Law provides, “Directors and senior managers shall not conduct the following acts: ...(5) without the permission of the shareholders’ meeting, take advantage of their posts to seek business opportunities for themselves or for others which shall have belonged to the company, or operate for themselves, or for others, the same category of businesses as are operated by the company they are serving...”

Article 32 of the Partnership Law provides, “A partner may not engage in any business in competition with the business of the partnership either on his own, or in cooperation with others.”

Paragraph 4 of Article 37 of Regulations for the Implementation of the Law on Chinese-foreign Equity Joint Ventures provides, “The general manager or deputy general managers shall not hold posts concurrently as general manager or deputy general managers of other economic organizations. They shall not have any connections with other economic organizations in commercial competition with their own joint venture.”

As can be seen from the above provisions, the subjects of the non-competition duty that is directly provided by the law are company directors, senior managers, partners of partnership companies, as well as general managers or deputy general managers of Chinese-foreign joint ventures. Generally, it refers to the duty when they are on the job. The duty will be resolved after they leave the company, for its loss of the posts of director or senior managers (people who signs non-competition duty contract with the company are not included).

2. Contract-bound non-competition Duty

The contract-bound non-competition duty mainly refers to the non-competition duty in the labor law field. An enterprise, by signing a non-competition agreement with its employees, reaches an agreement with the latter that the latter must not engage in businesses that are the same as or similar to their original posts while they work for the enterprise and for a certain period after they leave their posts. The Labor Contract Law and Interpretation of the Supreme People’s Court on Several Issues Concerning the Application of Law to Trial Cases of Labor Disputes (IV) both contain provisions on it. For example,

Paragraph 2 of Article 23 of the Labor Contract Law provides, “With regard to a worker who has a confidentiality obligation, the employing unit may have stipulated in the labor contract or confidentiality agreement competition restriction and payment of financial compensation to him on a monthly basis during the term of the competition restriction after the labor contract is revoked or terminated. If the worker breaches the stipulation on competition restriction, he shall pay penalty to the employing unit as agreed upon.”

Article 24 of the Labor Contract Law provides, “ The persons subject to competition restriction shall be limited to senior managers, senior technicians and other persons who are under the confidentiality obligation to the employing unit. The scope, geographic area and term of competition restriction shall be agreed upon by the employing unit and the worker, and such agreement shall not be at variance with the provisions of laws and regulations. The term of competition restriction, calculated from the revocation or termination of the labor contract, for one of the persons, as mentioned in the preceding paragraph, to go to work for a competing employing unit that produces or deals in the same type of products or is engaged in the same type of business as his original employing unit, or to establish his own business to produce or deal in the same type of products or engage in the same type of business shall not exceed two years.”

Interpretation of the Supreme People’s Court on Several Issues Concerning the Application of Law to Trial Cases of Labor Disputes (IV) contains more provisions, but it should be noted that not all are listed here.

As can be seen from the above provisions, enterprises may stipulate their employees’ non-competition duty by signing an agreement with the latter. Employees here mainly refer to senior managers, senior technicians or other staff with a confidentiality obligation, which makes contract-bound non-competition duty different from law-bound non-competition duty in duty origin and scope of application. In contracted non-competition duty, the company needs to pay an economic compensation to the employee concerned. The term of non-competition restriction shall not exceed two years, and may be lifted through negotiation.

II. Analysis of the Non-competition Clauses Commonly Seen in Private Equity Investment Agreements

Both law-bound non-competition duty and contracted non-competition duty are important measures taken to protect the target companies’ business interests, to which the private equity investors must pay close attention when making investment. To ensure smooth transactions and reduce investment risks, it needs to be clarified in the investment agreement the rights and duties of the investor, the target company and its shareholders, which poses higher requirements on the clauses of the investment agreement. Non-competition clauses that are commonly seen in investment agreements mainly include the following several types:

1. Non-competition promises and guarantees made by the target company’s shareholders and senior managers

Promise and guarantee clause is one of the most commonly seen clauses in private equity investment agreement. If any shareholder of the target company violates his promise or guarantee, he shall be deemed as violating the investment agreement, based on which the investor may investigate the target company and its shareholders’ liability for breach of contract. Related non-competition promises and guarantees mainly include the following aspects:

(1) The non-competition promises and guarantees made by the target company’s shareholders

Although the law provides the non-competition duty of partners of partnership enterprises, it does not provide company shareholders’ non-competition duty. However, if the target company’s shareholders have other investments that are the same as the target company’s businesses, it will inevitably affect the target company’s business performance. Therefore, the investor may require the target company’s shareholders not to make investment that is the same as or similar to the target company’s business and make a promise on that in the investment agreement. For example, the target company and its shareholders promise as follows:

1) The target company’s shareholders do not hold (directly or indirectly) any equity of another enterprise which is directly or indirectly in competition with the target company (except shares of a listed company not up to a certain percentage); 

2) Without the investor’s written consent, the target company’s shareholders are not allowed to establish or participate in the formation of a new business entity that runs businesses, which are the same as, similar to or competitive against the target company’s own businesses; and are not providing and will not provide consultation, guidance, consultancy, assistance or capital services in any form for any agency or person that engages in businesses competitive against the company’s own businesses. 

The target company needs to require its shareholders to make such promise if it intends to go listed on the new OTC market or issue IPO in the future. In case the investor plans to withdraw through the new OTC market or IPO, such promise and guarantee made by the target company’s shareholders are indispensable.

 (2) Promises and guarantees made by the target company’s senior managers and senior technicians that they don’t have the non-competition duty over their former employers

If the target company’s senior managers and technicians are subject to a  non-competition agreement that is in practice, it will inevitably affect the target company’s normal operation, and the target company may risk breaching the contract. Therefore, the investor may stipulate, in the investment agreement, the promises that it requires the target company and the target company’s senior managers and technicians:

1) There is no confidentiality agreement or non-competition agreement between the latter and any third-party company that may affect their fulfillment of their responsibilities in the target company;

2)  Although the target company’s senior managers and senior technicians sign a non-competition agreement with a third-party company, the target company is not in such third-party company’s list of non-competition companies, so it does not affect their fulfillment of responsibilities in the target company; 

3) The target company’s senior managers and senior technicians do not have pending arbitration, lawsuits or other disputes with any third-party company, or circumstances that may affect their performance of duties in the target company.

2. Non-competition provision in delivery terms

In general M&As, the investors will set some delivery terms and conditions in advance and will pay the investment funds only when such delivery terms and conditions are met. This is the case in private equity investment transactions. The delivery terms are crucial in an investment agreement, in which the investor may set strict delivery conditions and pay the investment funds only when the target company meets all delivery terms and conditions. Main delivery terms and conditions on the non-competition duty are as follows:

 (1) Delivery condition No. 1: The target company has signed an agreement with its relevant staff on the above promises and guarantees

According to the procedure of general commercial transactions, before the investor pays the investment fund, the target company’s relevant documents shall all be signed. As aforesaid, the target company’s shareholders and senior managers shall make promises and guarantees to the investor, and such promises and guarantees shall have been signed before the delivery. Therefore, before the investor pays the investment fund, the target company and its shareholders, senior managers and senior technicians shall sign the aforementioned promises and guarantees as a prerequisite for continuing the transaction, or the investor shall have the right to refuse to pay the investment fund.

 (2) Delivery condition No. 2: The target company has signed a Confidentiality Agreement and a Non-competition Agreement with its core staff members

When investing in the target company, the investor on the one hand injects, into the target company, the capital that is needed by the latter in its development, while on the other injects advanced business concepts into the target company. Where the target company is a hi-tech enterprise, its technical and business secrets concern its survival. To protect its technical and business secrets, the target company may sign a confidentiality agreement with its senior managers, senior technicians and other staff having the confidentiality obligation. For hi-tech enterprises holding a leading position in technology and focusing on R&D, they shall also sign a non-competition agreement with their core technicians in advance in order to prevent any loss of the target company due to the drainage of their core technicians. 

When signing the aforementioned non-competition agreement, attention needs to be paid to the following aspects: (1) Employees to perform the non-competition duty shall be confined to the company’s senior managers, senior technicians and other staff with the confidentiality duty. Therefore, the target company shall determine the objects of performing non-competition duty according to its reality to avoid full-coverage competition restriction. (2) The term of non-competition duty, if contracted to exceed two years, shall be invalid, and the term beyond the statutory term is not protected by the law. (3) A specific amount of economic compensation shall be clarified in the non-competition agreement, or the non-competition agreement may be identified as invalid. (4) In case it is unnecessary for the employees to fulfill the non-competition duty after a non-competition agreement is signed, a written notice to eliminate such non-competition agreement shall be issued to the employees when they separate from their posts to avoid unnecessary economic remedies. 

 (3) Arrangement of the delivery transitional period

The delivery transitional period lasts from the day the investment agreement is signed to the day the industrial and commercial registration of such transaction has been completed, and its length depends on specific transaction. During the delivery transitional period, the risk of the target company breaching the contract is inevitable given the information asymmetry between the investor and the target company as well as changes in the reality. It requires restriction of the rights of the target company, its shareholders, its senior managers and senior technicians: firstly, to request them to not violate the above non-competition promises and guarantees; secondly, to request them to inform, in a timely way, the investor of any fact, factual change or other situation that has caused or may possibly cause major adverse impacts on the target company so that the investor can deal with it as soon as possible.

3. Non-competition-related arrangements in the target company’s governance structure

Although a private equity investor mainly provides funds and seldom participates in the target company’s operation and management, it may designate directors or supervisors to participate in the target company’s administration to strengthen the latter’s supervision and avoid the latter to be out of control. The investor can also take advantage of its position as fund provider to request the target company to improve its governance structure, clarify the scope of key and core staff members who the target company needs in business operation, and get timely information on the target company’s staff change to prevent and control investment risks. Mainly, a private equity investor shall do the following:

 (1) Include core technicians in the scope of directors and senior managers

The investment agreement shall provide an appropriate governance structure for the target company’s development. Considering that core technicians play a significant role in company development, to prevent them from engaging in investment that is the same as or similar to the target company’s during their incumbency, it may be provided in the investment agreement that the target company may appoint its core technicians as directors, or it may be provided in the target company’s articles of association “core technical staff (e.g., technical directors) are the company’s senior managerial staff.” In so doing, according to the provision of Article 148 of the Company Law—company directors and senior managers have the statutory non-competition duty—the target company’s core technicians also have to perform the non-competition duty. It shall also be made clear in the investment agreement that appointment of directors or revision of the company’s articles of association is one of the delivery conditions for the delivery transaction.

 (2) Lock key figures

The key-figure clause is often seen in partnership agreements on private fund. Key figures are symbols of fund managers’ investment experience and investment performance. Many LPs, when investing in private equity funds, pay more attention to the key figures in the management team than the projects themselves. Similarly, when investors invest in target companies, they are investing in people in nature. Under some circumstances, the target companies’ founding shareholders, core technicians are even the key to the success of private equity investment.

Therefore, the target companies’ key figures may be clarified in the investment agreements. Such key figures may be the companies’ founding shareholders, core technicians or career managers, and the basis of determining them is whether they may affect the realization of the investors’ investment goals. Meanwhile, it shall be agreed upon in the investment agreement that such key figures (1) are not allowed to engage in activities that are competitive with the target companies’ businesses; and (2) are not allowed to separate from their posts or transfer the target companies’ equity that they hold within a certain period, or the investors will have the right to request the target companies’ shareholders to buy the company’s equity back.

 (3) Clarify the core team

When R&D hi-tech enterprises are involved in private equity investment, generally they are required to have a stable R&D team, because having a stable R&D team is directly related to the realization of the target companies’ goals. Therefore, it is necessary for the investors to clarify in the investment agreement that the target companies’ current R&D team members are their core employees with whom the target companies shall sign regulative Labor Contract, Confidentiality Agreement and Non-competition Agreement and also clarify in the investment agreement the rate of separation from posts of such core employees each year, or the investors will have the right to request the target companies’ shareholders to buy all or part of the equity back. 

4. Non-competition-related investor’s special right clauses

(1) Equity buy-back clause

In private equity investment, especially in projects where the target company is in urgent need of capital, the investor is in a relatively advantageous position, so the investor may include an equity buy-back clause that is in the investor’s favor in the investment agreement. As mentioned above, for investment projects where key figures and core employees have been determined, if key figures or core employees separate from their posts or have disputes with their former employers, it would inevitably affect the target company’s normal operation and realization of the investment objectives. Therefore, the investor may include an equity buy-back clause in the investment agreement.

In case of any of the following major events without the investor’s consent, the investor has the right to request the target company’s shareholders to buy all or part of the equity back from the investor: (1) the target company’s key figures withdraw or separate from their posts; (2) the target company’s current core team sees major changes; (3) the target company’s shareholders, senior managers and senior technicians engage in businesses that are in conflict with the target company’s interests, violate the non-competition promises and the duty of loyalty to the target company; (4) the promises and guarantees made by the target company’s shareholders and relevant staff are found to be inconsistent with the reality and cause the investor to suffer or possibly suffer a serious damage of interests.

(2) Co-sale right clause

As mentioned above, it is men that is invested in private equity investment, and private equity investment is special investment that is based on the trust of key figures. Therefore, there should be a circumstance under which key figures may change, the investor may exercise the co-sale right to withdraw in order to avoid uncertainties in the target company’s future development.

As aforesaid, after key figures are clarified, it may be provided in the investment agreement that if the target company’s key figures plan to transfer all or part of the equity that they hold of the target company to any third party directly or indirectly, the investor will have the right to, under equal conditions, sell a corresponding amount of the equity it holds to a third party which plans to buy the to-be-sold equity according to the shareholding ratio between it and the key figures.

 (3) Valuation adjustment clause

In case senior managers or senior technicians violate their non-competition duty, valuation adjustment mechanism may be adopted to adjust the target company’s valuation according to the actual loss that's caused to the investor by the above acts of tort. It is noteworthy that according to the current judicial practices, such valuation adjustment duty can be fulfilled only by the target company’s shareholders or other third parties, but not undertaken by the target company.

Such valuation adjustment clauses are what we usually call “gambling agreement”. It needs to note that the adjustment criterion determined by judicial precedents is: the gambling agreement with the target company’s shareholders is effective, but that with the target company’s is ineffective. Although the validity of the gambling agreement with shareholders is recognized now, China Securities Regulatory Commission has stressed many times on occasions of training insurance agents that “gambling clauses must be terminated before enterprises apply to CSRC for issuing IPO.” Therefore, such clauses shall be eliminated when the target companies plan to issue IPO.

5. Clauses on the termination of the investment agreement and liability for breach of the investment agreement

As aforementioned, the investment agreement sets the promise and guarantee clause. Once the target company and its associated personnel break their promises and guarantees, the investor will have the right to investigate the former of their liability for breach of contract. It may be provided in the investment agreement once the target company and its shareholders, senior managers and senior technicians violate the aforementioned promises and guarantees, the investor will have the right to terminate the investment agreement; or if the target company fails to meet all delivery conditions within a certain period from the day the investment agreement is signed, the investor may terminate the investment agreement. The investor may reach an agreement with the target company and its shareholders on the latter’s liability for breaking the above-mentioned promises and guarantees, and provide the way of calculating compensation.

III. Conclusion

Private equity investment has both risks and gains. In order to facilitate transactions and avoid risks to the maximum degree, the investors shall, on the basis of due diligence, strictly control the investment agreement clauses, and restrain the target company and its relevant staff with such clauses in order to protect the investors’ interests to the maximum degree. The non-competition clauses generalized here do not apply simply to the same investment agreement, and investors may choose to apply the aforesaid clauses according to different investment objectives.


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