Development and Protection: Key Terms of Restriction Agreements in Venture Deals
In IT venture deals, both the product and the founders, key persons, and other startup employees are of value to the investor. It’s hard to imagine a product succeeding and the business becoming successful without the involvement of its participants. Nowadays, when competition among startups is high, there’s a growing trend for investors to be particularly attracted by strong teams.
To maintain the stability of such a team after a deal, the investor, in addition to the main binding documents (share subscription agreement, shareholders' agreement), will insist on signing a restriction agreement.
In this post, we’ll explore the essence of this document and the key terms it contains.
A restriction agreement is a contract that imposes restrictions on the founders and/or key persons of a startup, and sometimes on the startup itself, for a certain period. The restrictions vary depending on the deal and can take many forms.
Restriction agreements are most commonly found in deals targeting the U.S. In deals structured in Cyprus, restrictions are typically included within the main binding documents. However, if restrictions need to be imposed on an employee who is not a party to the main documents, a separate agreement becomes necessary.
Let’s review the top five terms that are most commonly found in restriction agreements with founders and key persons of a startup:
Lock-up
Any business is about people, so investors are interested in keeping them on the team for as long as possible. A good income level and various bonus programs certainly help, but they don’t guarantee that a person will stay with the project for a long time. The lock-up helps achieve this goal.
Lock-up is a restriction on selling one’s stake in the startup for a certain period (2-3 years). This instrument ensures that the founder/key person will not leave the startup or sell their stake to a potentially undesirable third party during the lock-up period.
When encountering a lock-up in a restriction agreement, make sure the restrictions on certain individuals are justified. For example, an investor might impose a lock-up on minor shareholders who gained their shares through an option program but do not hold important positions, OR on business angels/investors from a previous round who have already achieved their strategic goals and reasonably want to exit the business soon. If you find the restriction excessive for certain individuals, be sure to make adjustments.
Vesting
Simply being in a project isn’t enough: a passive business participant is unlikely to bring much benefit. Founders and key persons must be involved in processes, achieving specific results. Vesting addresses this need.
Vesting is the gradual allocation of equity to the founders. There are two types:
- Traditional vesting, where the founders initially do not legally own their shares;
- Reverse vesting, where the founder owns the shares immediately, but the company has the right to buy them back during the vesting period.
For example, the parties may agree to a 4-year traditional vesting for a founder. Potentially, the founder’s stake in the startup could be 20%. The investor has set KPIs (key performance indicators) that the founder must achieve to receive the equity (e.g., develop several simple games and sell them at a certain minimum price). This means that by staying in the business and meeting the KPIs, the founder will gradually secure ownership of their shares. Ideally, after four years, the entire stake will belong to the founder.
Thus, vesting ensures a fair transfer of equity to a business participant based on their contribution and duration of work at the company. When analyzing vesting terms, ensure the investor has set reasonable timelines and achievable KPIs, and suggest alternative indicators if necessary.
Non-compete
The work of an IT business is closely tied to constantly acquiring unique information and technologies, requiring substantial effort and financing. Naturally, investors want to ensure that departing participants do not use these resources for personal gain, creating competition for the startup.
A non-compete clause prohibits engaging in activities that compete with the startup for a certain period (usually the entire time with the startup + 2-3 years after leaving) and in a specific territory (worldwide, U.S., etc.). Non-compete restrictions in restriction agreements help prevent the leakage of intellectual assets.
Always check the enforceability of non-compete clauses in a particular jurisdiction, as such provisions may not work everywhere. Also, pay attention to how the startup’s business, with which competition is prohibited, is defined. For example, if your startup’s business involves developing puzzle mobile games for U.S. users, ensure that the restriction agreement defines the business as specifically as possible. Otherwise, you may find that after leaving, you can’t work on any apps.
Non-solicitation
A startup interacts with valuable employees, partners, and clients, earning their trust. Therefore, another risk the investor will seek to prevent is the loss of employees and contractors to another business.
Non-solicitation prohibits founders/key persons from poaching the startup’s clients and employees for another business within a certain territory and for a specific period (similar to non-compete).
When reviewing this clause, as with non-compete, pay close attention to local regulations. In some jurisdictions, non-solicitation may be viewed as a violation of the right to work. Also, note what the restriction covers: prohibition on negotiating potential cooperation or employment, direct job offers, recruiting through third parties, etc. If you find these restrictions excessive for certain employees, adjust the terms to avoid negative consequences.
Non-disparagement
It’s crucial for a startup to attract new employees, clients, and investors. They often evaluate not only market potential and product quality but also the company’s reputation. Building a reputation is hard work, so it’s essential to make every effort to preserve it.
Non-disparagement is a prohibition against discrediting the startup, i.e., restricting the dissemination of negative information about the startup, its product, investors, etc., to strengthen the company’s market position. Non-disparagement usually includes a ban on leaving negative comments on social media, making ambiguous statements, or asking third parties to do so on your behalf.
When reviewing a non-disparagement clause, pay attention to how discreditation is defined, where the prohibition applies (including social media), whether there are exceptions for lawful actions and discussions, and the consequences of violations.
Although a restriction agreement somewhat limits founders’ flexibility in conducting business, its purpose is solely to ensure the startup’s security and the long-term protection of all parties' interests. With proper drafting, a restriction agreement minimizes risks and ensures stability in business processes, helping the startup grow in a competitive environment.
Authors: Nastassia Akulich, Alexandra Kovalyova
Contact our legal team to learn more
Write to lawyerDear journalists, the use of materials from the REVERA website in publications is possible only with our written permission.
To coordinate materials, contact us at e-mail: i.antonova@revera.legal or Telegram: https://t.me/PR_revera.