Issue
People (especially management teams) are a key value driver in any private equity investment. Restrictive covenants, including non-competition clauses (non-competes) in employment contracts are one of the tools regularly used by financial sponsors to protect that value. These provisions complement:
- restrictive covenants contained in shareholders agreements (SHAs) and sale and purchase agreements (SPAs) entered into by financial sponsors in respect of their portfolio companies; and
- the inevitably retentive effect delivered by granting to management of certain equity interests.
Non-competes are typically used in the UK to prevent certain key staff (generally senior management) from working for a competitor for a period of time after they leave their roles, and typically apply for between six and 12 months post-termination.
The UK government has recently proposed banning the use of non-competes that extend beyond three months from the end of an individual’s employment, arguing that this will encourage innovation and competition while protecting employees from unfair practices. A similar debate is taking place in the U.S., where some states have banned or limited the lawfulness of non-competes (most recently in New York).
Although the typical length of non-competes in executive and manager employment contracts has generally reduced over the last five years, three months would be very short for senior executives and managers and would be considerably shorter than UK market standard for individuals at this level.
UK government’s proposals only apply to non-competes in certain contexts
Financial sponsors regularly implement management incentive plans, giving top managers the opportunity to invest in the target business and gain exposure to potential equity upside, which they are usually required to relinquish on resignation (with the terms being set out in the applicable SHA). Alongside this there will almost always be restrictive covenants in the SHA which kick in when the manager ceases to be a shareholder, bolstering the covenants in the manager’s employment contract.
Restrictive covenants in SHAs typically last two years, which the English courts are likely to consider enforceable on the basis that there is more equality of bargaining positions in commercial agreements such as SPAs and SHAs than is typically the case in employment contracts (notwithstanding that the individual managers signing SPAs and/or SHAs are usually also employees).
Notably, the government’s proposals apply to non-competes in employment contracts but not in other commercial documents such as partnership agreements, LLP agreements, SHAs and SPAs. There is slightly less certainty at this stage on the application of these proposals to deferred remuneration schemes such as LTIPs and option schemes, among other things.
Solutions
The UK government’s proposals have prompted some financial sponsors to consider creative solutions to further protect their investment interests if the changes are implemented.
One such option is to amend managers’ employment contracts to include longer notice periods and make greater use of existing or newly implemented gardening leave clauses instead of relying non-competes (which typically apply post-employment).
This model would require the individual to be paid (eg base salary only) for the duration of the notice period, while preventing them from taking up employment elsewhere.
This approach has its own costs and risks and will likely only be suitable for the most senior managers and executives.
Fixed-term contracts for top managers
Another option that some private equity firms may wish to consider for top management is the use of renewable fixed-term employment contracts. Here, instead of having indefinite term employment contracts terminable at any time by either party (on provision of notice), the employee would have, for example, a four-year contract that can only be terminated in the last six months prior to expiry, before automatically renewing.
This would make it harder for employees to quit to join a competitor, and protect the company's business interests for longer. It would also have the effect of driving stability of management teams on a timeline that potentially aligns with the horizon of the private equity investor (and likely also any management equity arrangements).
The proposed change will inevitably drive focus on the armoury of other employment and post-employment covenants typically used in management employment agreements, such as non-solicitation covenants, non-dealing covenants and non-poaching covenants and confidentiality provisions. Companies would be well-advised to revisit these and ensure that these are fit for purpose.
Changes to employment contracts require employee consents
Except where otherwise authorized by an existing term of the contract, any changes to employment contracts require employee consent, which would need to be obtained either at the point of hiring or later in the employment relationship (which would likely require payment to ensure that the changes made are enforceable).
A revised approach to manager employment contracts would also need to be lined up with the business protections sitting in management equity plans, SHAs, SPAs and other contractual documentation (which, are not targeted by the UK government’s proposals).
As noted above, the English courts generally consider that restrictions in such documents can be more onerous and greater in duration than those in manager employment agreements, but it remains to be seen whether such an approach will prevail in the event of a change to the law on non-competes in employment contracts.
Whatever happens with the proposals, all employers and business owners, including financial sponsors, will continue to seek ways to protect their business interests via more innovative contractual structures. In time, we anticipate that any evolution in these agreements is likely to be tested in the English courts, which will both look to apply restraint of trade doctrines to provisions which look to prevent managers from moving roles, and seek to ensure that employees are not unlawfully penalised through the resultant structures.
