So you want to buy a high tech company. Well, papering the legals for a high tech deal presents a number of challenges beyond those that exist in any asset or share purchase transaction. The significant additional dimension is speed - high tech M&A happens in Internet time, at a very fast pace. And yet, there is still much legal work to be done on such a deal. So herewith some suggestions if you are contemplating acquiring a software or some other high tech company, or a "traditional" company which has material IT or IP assets (referred to as the "Target").
Phased Disclosure of Confidential Information
Prior to being allowed access to confidential information about the Target, you will invariably be asked to sign a non-disclosure agreement ("NDA"). Under the NDA you will undertake to keep confidential the information you learn about the Target. Even in the absence of a NDA agreement, you likely will have a legal obligation not to disclose confidential information learned from the Target.
As a result, sound advice for you as the purchaser – as well as for Targets – is to be very careful about how information on the Target is disclosed to the potential purchaser. Remember, forbidden fruit (in the form of trade secrets or highly sensitive confidential information) is the tastiest, so you’ll have to be careful to restrain your technical staff as they give the Target’s technology the once over.
For example, if you are particularly interested in the Target’s software assets, you should not review the source code (the high level crown jewels of a software program) for the software until you have a general understanding of the business parameters of the deal. Thus, the business people should reflect the core points of the deal in a letter of intent before the engineers begin their due diligence review of the guts of the software.
Even this review by engineers should be done in stages, and should go no further in each stage than is necessary for you to determine that you do not wish to go to a further stage. By following such a phased disclosure approach, you can attempt to minimize the risk of being contaminated with the trade secrets and other proprietary information of the Target.
The danger to guard against is that the deal ultimately does not go forward, but you’ve learned a great deal about the Target’s technology. This would lead to the suspicion that any competitive products that you released subsequently contained secret elements of Target’s technology. It is therefore in both parties’ best interest to control very carefully the exposure of the purchaser to the trade secrets and confidential information of the Target.
Target companies will often ask that the NDA contain an employee no-hire clause; that is, if the deal does not proceed, the prospective purchaser not be entitled to hire any staff of the Target for some period of time. The ostensible purpose is that the prospective purchaser be unable to use (or mis-use) any staff-related information it learned during due diligence in order to hire those very people. Many prospective purchasers will balk at a general non-hire restrictions, but will often agree to a narrower non-solicit provision.
Understand What You are Buying
This sounds trite, but you must understand what you are buying, and why. This means more than knowing the difference between purchasing shares or assets, though of course this is an important question as well. Rather, you have to decide if, for example, you are buying a balance sheet, or merely some intellectual property assets and access to people.
For instance, many high tech start ups are in fact little more than some valuable technological assets and a handful of key and even more valuable people. At the other end of the spectrum, if the Target is a long established software company with sales in the tens of millions of dollars, you will also be "buying" this business’ financial statements.
These two different types of deals present the purchaser with very different risk profiles. The due diligence for these two deals would, therefore, but quite dissimilar. The representations and warranties in the definitive purchase agreement would also look different. So, before you embark on these stages of the deal, you need a clear picture of exactly what you are buying.
Agree on Valuation Early On
Once you have decided what you are buying, it is necessary to determine what you will pay for it. This sounds like a rather straightforward exercise, but valuing knowledge-based companies, or certain of their assets, is fiendishly difficult.
Asset-based valuations are, for the most part, not relevant because the value of the high tech assets – such as software or patents – carried on the books rarely indicates their true value. Earnings-based valuations can also be tricky, given that many technology companies have uneven earnings.
So you will likely need to come up with some new valuation methodology that better captures the dynamics of your market space. Some companies base their valuations on, for example, so many dollars for each engineer of the Target, coupled with what market leadership the Target’s novel technology can afford the purchaser, and how quickly. On the other hand, for a more mature software company with significant sales, a valuation based on a discounted cash flow model may be entirely appropriate.
Whatever the parameters driving the valuation, the key is to agree upon the approach early on, and to have an understanding that it will be adhered to even if the various numbers driving the formula change as the due diligence exercise unfolds and reveals some surprises. There are lots of high tech M&A deals where valuation questions plague the participants throughout the acquisition process, and a lot of angst can be avoided if the valuation rules of the road are firmly established early in the process.
Do Tax Homework Early
The tax regime applicable to all acquisition scenarios is complex and often times unruly. With technology-based deals, the tax issues can become even more complicated.
Should the technology assets be purchased by your off-shore affiliate to try to take advantage of international tax planning opportunities? Or perhaps they should be purchased by a Canadian entity to take advantage of our fairly generous tax write off rates for software. How should the going forward business be structured to capitalize on R&D tax incentives? If there is a Canada-U.S. dimension to the deal, as there often is, how will future intercompany transfer pricing come into play?
The sellers of the business will also be asking a bunch of tax-related questions. If the purchaser is a U.S. public company, and shares of this company are to be received by the Canadian-based sellers, how can the so-called exchangeable share vehicle be used to defer Canadian income tax until the Canadian sellers are ready to liquidate their shares? And will the $500,000 capital gain exemption be available? Or, if options are part of the compensation package going forward, how will these be treated?
These are just some of the important tax questions that can arise on the sale of a high tech business. So all parties need to get their tax advice early. Given the speed with which these deals need to move, tax advisors need to be consulted at the earliest stages of the transaction, ideally even before the letter of intent is signed.
Letter of Intent
Assuming your discussions with the Target company are progressing well, it’s time to prepare a letter of intent. This document sets out the core business parameters for the deal: who is buying what, the purchase price, any phased payment process for the purchase price, expectations surrounding employees, and other key deal points.
How long should the LOI be? I’ve worked with short ones (i.e.- two pages long), and lengthy ones (i.e.- north of 15 pages). The length will of course be a function of the complexity of the deal. The more moving parts to the transaction, the longer the LOI. Also, some parties find it useful to highlight in the LOI a number of the key provisions that they will expect in the definitive purchase agreement. This can greatly reduce negotiation time later on. On the other hand, it can also bring the deal to a grinding halt, so in each case you have to think through the strategic and tactical ramifications of a short versus lengthy LOI. To do this well, legal counsel needs to understand the objectives of the parties, the negotiating dynamics, and other important factors.
Should the LOI be binding? That depends. In some cases the parties want a document that is truly binding, save and except for the satisfaction of one or more conditions. In this case, you are really not talking about an LOI, but rather something like a memorandum of understanding that is binding in and of itself, whether or not it is superseded by a lengthier document.
The typical LOI, however, is not binding as to the terms of the deal, but merely reflects the business people’s thinking about price and other key factors, all of which are not carved in granite until a definitive purchase agreement is signed. Nevertheless, the deal points in an LOI do represent an important psychological commitment to most business people, and in my experience relatively few LOI’s do not result in concluded deals. Thus, notwithstanding its non-binding nature, you must take very seriously the LOI. It’s a small high tech M&A community. Any person that walks away from signed LOI’s with regularity will soon be cut out of the all important deal flow.
Even when the general points of an LOI are non-binding, certain aspects of it are made legally effective, such as the requirement that parties keep each other’s information confidential. A Target often extends this to include that the prospective purchaser not be able to hire or solicit any of the Target’s employees for a period of time if the deal does not proceed, as noted above.
Another typical binding provision is the so-called A no shop@ clause. This requires that the Target negotiate only with the other party to the LOI for a period of time, typically in the 30 to 90 day range. This exclusivity gives the preferred acquiror comfort that, although the success of its own deal is not assured, the Target will not be scooped by someone else for a period of time.
So the LOI is signed and the (usually purchaser’s) lawyer has begun to prepare the definitive purchase agreement. This is the time when you will undertake vigorous "due diligence" on the Target, the process by which you review intensely the operations, financial condition, intellectual property and other important aspects of the Target.
In many respects the diligence you undertake on a high tech company is similar to the process you would follow with any type of business. A key difference, though, relates to intellectual property, often the crown jewels of a high tech company. What follows are specific diligence tips for various high tech assets.
Patents. Patents are the trump cards of the intellectual property world, inasmuch as they can afford effective exclusivity, and in certain cases monopoly profits. Importantly, independent creation is not a defence to a patent claim, so patents are indeed the strongest form of intellectual property protection. And while patents were once restricted to the mechanical devices in high tech products (i.e.- the head reading component in a disk drive), today, especially in the United States (the key market for any technology company), patents are being granted for software features and even methods of doing business over the Internet.
Accordingly, conducting comprehensive diligence on a technology company’s patent portfolio is important. Are the patents in good standing? Has the Target filed corresponding patents in key foreign markets? And what is the overall scope of protection of the patent portfolio? Is it broad or narrow; in effect, what is the economic value of the patent portfolio?
If the Target does not have registered patents, a patentability search may be appropriate, both for defensive and offensive reasons. The former refers to the risk that the Target’s products or R&D infringes a third party’s patents, even if other patent owners have not yet asserted demands. The latter refers to the potential economic value to be reaped by the purchaser of the Target if the Target’s technology is patentable.
Copyright. If the Target’s key products are software-oriented, the diligence process will want to review the copyrights in such programs. There are voluntary copyright registration systems in Canada and the U.S., and searches should be conducted in both. The copyright in most software, however, is not registered, and even if it is, a thorough A author-based title search@ should be undertaken anyway.
Copyrights in software and related documentation arise when people (i.e.- software programmers, technical writers, etc.) create the program or write the documentation. Thus, you will want to be sure that anyone who contributed to the copyright materials, whether they are employees or contractors (or employees of contractors), has, either by operation of law (in the case of copyright – but not moral rights – employees who create works in the course of their employment) or typically by contract, have transferred their copyrights, and waived their moral rights, in the relevant work.
Trade-Secrets. Software and other technology assets can also contain trade secrets. There is no registry system for trade secrets. Therefore, it is a case of reviewing the Target’s information handling practices to ensure they have taken the steps necessary to preserve the secrecy that judges look for to satisfy a trade secret claim. These include: physical security of the premises (i.e.- locked doors and filing cabinets); computer/network security; and contractual protection through confidentiality provisions in employment, customer and other agreements with third parties that are given access to the trade secret.
Trade-Marks/Domain Names. Trade-marks can be protected at common law (under the doctrine of passing off), or, preferably, under the relevant country’s national trade-mark registration regime. Therefore, as with patents and copyrights, searches of the national registry (in at least Canada and the U.S., but possibly other key markets as well), will be in order, again for both defensive and offensive reasons. Of course judgment has to be exercised here as with all aspects of the diligence review; if the Target’s products will be rebranded with your own marks, then the whole question of trade-mark diligence is downgraded in importance.
Do not forget about the relatively new mark-related asset, the Target’s domain name, either in the .com, .ca or other space. As these registrations become critical for the Target’s Internet presence, they are acquiring ever increasing value. Indeed, if the Target is an Internet-based seller or similar service provider, the domain name may be a key asset. Generally, however, a registered trade-mark for a particular good or service can override a domain name registration in a similar line of business. Thus, if the Target only has domain names, you have to review carefully who owns the corresponding off-line trade-mark registrations.
Web Site. If the Target is a dot.com or an Internet participant whose primary business is operating a Web site, then you will want to look closely as part of diligence at the license or other rights that the Target has for all the material, software and content on its Web site. Also very important will be the Web promotion, licensing and related agreements that the Target has in place buttressing its business. These types of material contracts can be the heart and soul, both operationally and economically, of the Target if they are in the Internet space. You will also want to understand how privacy laws affect the Target, and what degree of compliance the Target has had with such laws.
Software Products. Besides the core intellectual property issues discussed above, other questions regarding software (and often other technology-based assets) have to be pursued during diligence. What third party software is used to create, or indeed are embedded in, the Target’s products? It is rare for any software product to be built from scratch nowadays. As a result, understanding what belongs to the Target, and what is merely licensed by the Target (with technical and financial implications) becomes important.
One third party software issue that is particularly germane relates to open source software (OSS). OSS is being used ever more widely, and presents a particular risk for software companies because some OSS products can "infect" the company’s proprietary software and make it open source as well, thus potentially causing an erosion in value to the software company. Understanding fully this issue is a critical objective of due diligence.
Also relevant will be exploring thoroughly the quality of the technology, in terms of known problems, customer concerns, support processes, and possibly key development plans (i.e.- are you buying a stable but leading edge product, or a soon to be obsolete program that will need an entire rewrite within days of your purchase). Obviously the findings related to these matters will drive the discussions surrounding purchase price, or may cause you to reconsider the deal altogether.
A further area in need of diligence-related analysis relates to the exploitation of the software product. Have any customers been given access to source code, the highly sensitive crown jewels of the program?, or have OEMS, VARS and other acronyms been given distribution rights, particularly of an exclusive nature for any geographic or vertical market? Again, the exercise is a variation on Plato’s adage, A the truth shall save you money, time and (hopefully) grief@ .
Process. From even this brief discussion, it is readily apparent that proper diligence takes time. Therefore, start as soon as possible. And be methodical. Compile notes and observations in a structured, organized manner; this investment will pay solid dividends when you have to integrate the Target after the acquisition.
The Purchase Agreement
So, you have completed the diligence review, and you still want to buy the Target. It’s a private company (one that is not listed on a stock exchange; public company M&A deals raise a number of securities law issues not discussed below). You have considered thoroughly the due diligence issues raised above, and you are still keen to complete the deal. Accordingly, it’s time to prepare the purchase agreement (the "agreement").
In many respects the agreement will resemble the form of document used to acquire any type of business. It will also, however, contain provisions specific to, or modified for, the acquisition of high tech assets, and these will be highlighted below.
Acquisition Mechanics. The age old questions that determine whether to acquire shares or assets will have to be asked in a high tech deal as well. An important element in this analysis will be the nationality of the purchaser. A good many buyers of Canadian tech companies are American. As a result, numerous tax-driven alternatives present themselves, and solid tax advice on both sides of the border will be required to achieve an optimal solution for buyer and seller alike.
Some of the alternatives include: using a Nova Scotia acquisition vehicle to achieve favourable tax results for the U.S. purchaser; or selling the software assets to an affiliate of the U.S. purchaser to achieve long term tax planning goals. From the sellers’ perspective, if all or part of the consideration will include shares of a U.S. high tech company purchaser, an increasingly common event, then a relatively standard procedure is for the sellers to receive exchangeable shares of a Canadian affiliate of the U.S. company, thereby deferring tax on the deal until these shares are exchanged for the U.S. public company shares. Upon this exchange, the sellers will also want to ensure that they can sell these shares right away, so a registration rights agreement affording this privilege should be negotiated at the time of the original deal.
Another key mechanism in many acquisition deals is the holdback by the purchaser of a portion of the payment (whether cash or shares). The sellers will make a number of promises about the company (see representations and warranties below), and if any of these prove to be inaccurate, the purchaser is entitled to claim his damages, including offsetting them from the holdback. A variation on this theme quite common in high tech company deals is that the shares of the public company purchaser issued to those sellers who are to become managers at the purchaser upon the closing of the acquisition, must be given back these shares if the seller/manager resigns within a few years after the deal.
Purchase Price Adjustment. If purchase price valuation is being driven (at least partially) by the state of the Target as reflected in financial statements that pre-date the closing by a number of months, then the agreement will usually have a purchase price adjustment mechanism to deal with any changes in the state of the business between the date of these financial statements and the closing. That is, the parties will typically provide that upon closing, the Target must have a tangible net worth ("TNW") of a certain amount, or at least have working capital ("WC") of a certain amount.
Having provided for a TNW or WC target to be achieved upon closing, the agreement will go on to provide that fairly soon after closing a closing date balance sheet will be prepared, so that the closing date TNW or WC can be computed. Then, if the actual results differ from those targeted, a payment is made from or to the purchaser in the amount of the difference.
Another purchase price adjustment is the "earn out". This is typically a mechanism to bridge the gap in (perceived) value between the two parties. Thus, the purchaser does not believe the Target is worth as much as the seller, so they provide for an earn out whereby if certain (typically ambitious) performance goals are met by the Target within a year or two after closing, extra consideration is paid to the seller.
While the concept is easy to state, earn outs can be fiendishly complex to operationalize and draft. The key problem is that businesses – and especially high tech businesses – change so quickly. So, for example, what happens when the Target’s core product gets bundled with the purchaser’s products; how do even top line results for the Target get calculated? Or what if the purchaser makes significant changes in the Target’s product line? In short, business people like earn outs, but lawyers do not. They can be the cause of much angst and dispute.
Representations and Warranties. From the buyer’s perspective, a very important part of the agreement is a (usually long) set of promises and statements about the company (or assets being purchased) made by the sellers. These representations and warranties give a comprehensive description of the financial and legal state of the company being purchased.
As with the due diligence exercise discussed above, the particularly important representations and warranties relevant to a high tech deal will include those addressing the ownership of the intellectual property assets. The purchaser will want assurances that it will obtain good title over these intangible assets, and that they do not infringe the intellectual property rights of third parties.
In a similar vein, a thorough purchaser will address, through representations and warranties, the following about the software assets it is acquiring: who has had access to the software’s source code; all developers have waived their rights in the software; who has distribution rights to the software; are there problems or design flaws in the software; what are the development plans for the software; etc. The overall objective here, as with the due diligence exercise, is for the purchaser to get an accurate picture of the business/assets it is buying.
When a high tech company is being sold, it is standard that the selling shareholders give the required representations and warranties, and therefore be responsible financially for any subsequent claims. This is entirely appropriate as they are being paid the purchase price. By contrast, where an investor is putting money into an early stage technology company, it is not always the case that the existing principal shareholder personally stands behind the representations and warranties being given the investor, primarily because the new money is going into the company and not being paid to the principal personally.
It is important to understand the temporal dimensions of the representations and warranties in a high tech M&A deal. These statements are made as of, and speak only to, the state of affairs existing at the date of the closing of the deal. Therefore, issues which arise after the closing based on facts that arose after the closing are not the responsibility of the seller; on the other hand, liabilities which are based on facts that were in existence at the closing are still the seller’s responsibility.
But for how long should even this responsibility continue? Or to use legal parlance, how long should the representations and warranties survive? The range can be anywhere from six months to five years (or even longer - indeed indefinitely - on matters such as ownership of the shares or technology being sold). Typically, different representations would survive for different periods, with tax and ownership (including infringement matters, in respect of the technology-related assets) continuing for a relatively long time, while financial items might last only until several months after the next regularly scheduled audit.
Indemnities. Most agreements provide that the seller will indemnify the purchaser for any losses or damages sustained by the purchaser for a representation or warranty ultimately proving to be inaccurate or false. In technology deals, such indemnities often come into play due to an overstatement of revenues (i.e.- the company was too aggressive in its recognition of revenues from sales of software licenses) or an underpayment of sales taxes on software license deals, though a number of other representations and warranties can also prove to be problematic.
In many agreements, sellers are able to negotiate threshold provisions whereby the indemnity mechanism does not kick in until a certain dollar amount of claims have been aggregated. The related interesting question is whether this amount should be a complete deductible or, as purchasers prefer, once the amount is reached, the full amount (back to the first dollar of losses) can be claimed.
The other dollar amount that is often negotiated is the maximum that can be claimed from the sellers. A common negotiated compromise is the total proceeds received by the sellers from the purchaser. Conceivably this amount will cover just about any type of claim imaginable, though intellectual property infringement actions brought by third parties could exceed this amount.
If the agreement contains a purchase price adjustment mechanism (see discussion above), then there is a potential overlap between recovery under breaches of representations and warranties, and the purchase price adjustment. Therefore, a provision should be added to the agreement that avoids potential double counting (that is, recovery under representations and warranties should be reduced to the extent the purchaser has already been compensated for the same matter by the price adjustment mechanism).
Closing Conditions. In some deals, the parties can sign the purchase agreement and close the deal on the same day. More typically, however, the agreement is signed, but the actual sale does not occur for some period of time, until certain conditions to closing are satisfied.
Perhaps the most usual condition, particularly on larger transactions, is obtaining approval of the relevant anti-trust/competition law authorities. In many jurisdictions one or both parties have to notify the competition law authorities that they are contemplating a merger, and cannot consummate the deal for some period of time, during which the government, if it was concerned about the adverse impact on competition of the business combination, could proceed to block it.
As a result of these and other closing conditions, the agreement must also address what restrictions apply on the operation of the business during this interim period while the seller still owns the Target, but the purchaser has a binding agreement to buy it. To a certain extent, the purchase price adjustment mechanism (discussed above) is very helpful here, inasmuch as it makes the purchaser somewhat less nervous about how exactly the Target is being run in the interim, given that any out of the ordinary course behaviours will result in a purchase price adjustment.
Non-Competition Covenant. It is extremely common in high tech acquisitions that the seller(s) agrees not to compete with the business being sold for a period of time after the sale. This is a crucial provision where, for example, a key individual or two was responsible for designing most of the target company’s core software. If these people could immediately start up a competing company, the value of the acquisition to the purchaser would be hugely diminished.
The important question, of course, is what length of non-compete restriction is reasonable under the circumstances. In Canada, a period ranging between two and five years is common. And while courts tend to look unfavourably on non-compete clauses generally, they have a much higher tolerance for them when they are related to the sale of a business. Nevertheless, these provisions should still be crafted carefully, particularly in respect of their geographic scope, although many technology businesses will be extremely international in their sales channels.
Don’t Forget About The People
So you’re just about done buying a high tech company. You’ve considered the matters raised above - you have done your due diligence on the target company you are acquiring, and you have an effective acquisition agreement that addresses the myriad of intellectual property and other issues presented by high tech M&A deals.
Now you must avoid a common mistake in technology-related transactions, namely forgetting about the people. It is easy, and sometimes not incorrect, to think of a tech company’s software, patents and other intellectual properties as its most valuable assets. Very often, however, the human assets that go up and down in the elevator each day are just as important, if not more so.
Therefore, retaining key employees of the target becomes a critically important objective in any tech-related M&A deal. This is not, however, a trivial exercise. We live in the age of free agency. Mobility of people in the tech sector can be characterised as nothing short of peripatetic. A client of mine who heads up the human resources function at a software company commented recently that 10 years ago a job candidate with more than two stints of employment in the previous six years would be considered as problematic, someone who couldn’t hold down a job. Today, she went on to say, anyone with fewer than three jobs in the same period is considered non-entrepreneurial (and hence, quite a bit less attractive).
So the name of the game in high tech (and, by the way, the legal profession) is employee retention. How is this done, especially with the principal sellers of the target company who stand to pocket millions of dollars each on the sale of their company?
The first retention vehicle, at least in the context of the acquisition of the target, is not to pay the millions all at once. Rather, the payments can be made over time, say over three years with 25% of the proceeds paid on closing, and 25% on each of the three anniversaries of the purchase. Moreover, the purchase agreement would stipulate that if the employee resigns or is terminated for cause prior to the end of the three year period, the remaining shares are forfeited.
There are an number of variations on this reverse vesting theme. Some employee sellers require that the shares vest, and the payments are made, on a monthly (rather than annual) basis, so that fewer shares are left behind if the employee leaves prematurely.
A close cousin of the reverse vesting mechanism for shares purchased form individual principals of a company who are expected to continue with the company after the sale, is the employee stock option plan (ESOP). ESOPs come in many shapes and sizes, but in essence they involve the issuance of shares of the company to employees to incentivize them to perform as well as they can. In many high tech companies, options (and the shares they ultimately represent) are absolutely key to the attraction and retention of staff.
The retention dimension is implemented by having the options vest over time, and/or based on performance. That is, equity in a company is typically not merely given to an employee, but rather is earned for past service. At one time Canadian tech companies were quite miserly with spreading equity among employees, but that is changing now. Today, it’s not uncommon to see software companies allocate to staff as much as 20% of the shares of the business.
Thus, on the acquisition of a tech company, there is often some combination of reverse vesting for the existing shares and an ESOP for the issuance of new shares, to help ensure that key people of the business continue to work for its on-going success.
Employee Shareholder Agreement
Technology companies that are still private (that is, have not yet gone public and listed their shares on a stock exchange) and that issue shares to employees should have these staff sign shareholder agreements in respect of these shares. These agreements would cover a number of important objectives.
Perhaps most critical is to provide that if there is an offer to buy all the shares of the tech company, often referred to as a A liquidity event@ , the employee will tender his shares into such a deal provided he or she is paid the same amount per share as other shareholders. This is a key provision, because purchasers of tech companies invariably want to buy 100% of the issued shares, and do not want to have to deal with minority shareholders on an ongoing basis after the acquisition. Therefore, it is extremely important that the majority shareholders be able to A drag along@ the minority, as such a provision is euphemistically called.
Other terms in such an agreement would include that the employee shareholder cannot sell his shares except at the time of a liquidity event, or with the prior consent of the company (and then only to other employees, but not to third parties). Again, the key point is that these shares are being issued to incent the staff, and should not be sold or transferred until the occurrence of a liquidity event (such as a sale of the company) or until it goes public and the shares are tradeable on a stock exchange.
From Carrots to Sticks
Sometimes stock-based incentives are not enough. Perhaps the employee is in year three of a four year reverse vesting or ESOP program, so she’s received the majority of her consideration, and she wants to leave to start up a new company or maybe to join some other business. This is why, as noted above, having her sign non-competition restrictions when she sold the company was so important.
The first non-compete clause would have been in the purchase agreement under which her company was acquired. These sorts of non-competes range in duration from two to five years, generally, and normally restrict the seller from carrying on a business during this period that competes with the entity being sold.
The rationale for this sort of restriction is relatively straightforward, and courts do not have an objection to them, for the most part, so long as their scope and duration are reasonable. In short, in an industry where people are so important, the purchaser of a high tech business would not receive adequate value for his dollars if the principals of the target could simply start up a competing entity the day after the sale. Why would anyone buy Microsoft (assuming they could afford it), if Bill Gates could start up a competing enterprise the next day.
A second non-competition provision will likely be attached to the principal’s employment agreement. This will be for a much shorter period, generally in the six to eighteen month range. These are non-competes that come under particular scrutiny from courts. Indeed, in a recent case in New York State, a judge struck down such a clause prepared by an Internet company that imposed a one year restriction; the court, endorsing the sentiment that A Internet time@ moves much faster than regular time, argued that 12 months in the context of the Internet is the equivalent of a much longer period in any other industry. By contrast, however, in one Ontario case, the court upheld in favour of a software company a six month non-compete that was suitably circumscribed and limited to Canada and the US.
In addition to non-competition provisions, tech companies will routinely have staff agree to accept restrictions on the ability to solicit employees or customers of the business, generally for periods of between six to eighteen months. Courts are somewhat more favourably disposed to these types of limitations, particularly if they are narrowly drafted.
With all of these restrictive provisions, you will want the employee to sign such an agreement prior to their commencing employment with you; ideally, these terms are attached to the offer letter, so it is crystal clear that they are part and parcel of the employment relationship. If they are signed up only after the commencement of employment, there is a risk of unenforceability for lack of consideration.
Wind and Sun
In conclusion, the legal environment for employees of high tech companies can involve both the wind (such as non-competition provisions) and the sun (such as stock options). A thoughtful employee retention program will invariably utilize both approaches, as well as a number of extra-legal measures related to providing staff with nifty, cutting edge, important projects to work on (in my experience this is what really motivates bright, young, technically savvy people to stick around). Carrots and sticks, the wind and the sun; these are all helpful in building a first rate organization within the technology company.
George S. Takach is a partner in the Toronto office of McCarthy Tétrault, where he is Co-Head of the National Technology Law Group. McCarthy Tétrault is Canada’s pre-eminent law firm in tech matters, as ranked by the peer review-based Lexpert Canadian Legal Directory.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.