startups

restraints of trade in New Zealand in the corporate context

Restraints of trade are commonly used in New Zealand contracts – from mergers and acquisition(M&A) deals, in shareholders’ agreements and employment / contractor arrangements. They help protect business value, but if drafted too broadly or without clear justification, they risk being unenforceable.

In M&A and capital raising transactions, buyers and investors will carefully review restraints on founders or key employees / contractors to ensure there is the necessary protection of IP, customer relationships, and know-how.

This guide outlines the types of interests that can be protected, key factors courts might consider, and how restraints are typically applied in corporate transactions – along with some practical tips.

Restraints presumed invalid unless reasonable

The landmark case of Nordenfelt v Maxim Nordenfelt Guns & Ammunition Co [1894] held that a restraint is prima facie unlawful, but it may be upheld if it is reasonable in the interests of the parties to the contract and with reference to the interests of the public.

To be enforceable, a restraint must:

protect a legitimate business interest
go no further than reasonably necessary in terms of duration, geography, and scope.

In short, the restraint must provide adequate protection, but nothing more.

What can be protected?

A restraint cannot simply prevent competition for its own sake. The law will not protect a party from ordinary commercial competition. Instead, the restraint must be connected to a specific interest, such as:

trade connections (e.g. client or supplier relationships)
confidential business information
know-how or intellectual property
goodwill of a business being sold.

Two common types of restraint clauses

Non-compete

Prevents a person from working for, or establishing, a competing business within a defined area and timeframe.

Non-solicitation

Prevents a person from contacting or poaching former clients, customers, suppliers, or employees. These tend to be narrower and more enforceable, especially in the employment context.

Reasonableness of restraint depends on scope

Restraints must be reasonable and proportionate. Courts will closely examine the scope of the restraint if necessary, considering:

1. The activity being restrained

Is the restriction narrowly targeted (e.g., preventing contact with certain clients) or a broad ban on competing in an entire industry? Narrow restraints are more likely to be enforceable. E.g. in the AANZ template shareholders’ agreement, a competing entity is defined as any business or other undertaking, which is directly competitive with the Business or any material part of the Business. The defined term Business should be reviewed carefully and, in some cases, a narrower defined concept of Restricted Business may be required.

2. The geographical area

A restraint covering a small local area may be reasonable for a small business; a nationwide or international restriction may be justified for a larger company. If the business is likely to expand overseas, consider if the geographical area should include jurisdictions where the business might operate in the future.

3. The duration of the restraint

While no strict limits exist, restraints lasting 3 years are generally seen as the upper bound in the M&Acontext (see below), but employment restraints tend to be much shorter (e.g. 3 -12 months). But each must be justified.

In addition, restraints in employment / contractor agreements could receive closer scrutiny if challenged, especially if the employee or contractor is junior, the restraint is broad in scope, or the employer cannot identify a specific protectable interest.

Uses in corporate transactions

M&A

Restraints are generally included in sale and purchase agreements as part of M&A deals. They apply to the sellers (whether in share or asset sales) with the rationale to protect a business’ core working knowledge, and ultimately the goodwill being transferred. While a buyer is likely to prefer that the restraints to apply to all sellers regardless of their involvement in the business, there are typically exclusions for:

private equity, venture capital and other institutional investors for whom restraints are simply unworkable; and

large groups of small sellers.

Buyers typically require non-compete and non-solicitation clauses binding sellers for at least 24-36 months post completion of the sale. Restraints on the sellers of a business in favour of the buyer are upheld more readily than restraints on an employee in favour of their employer. This reflects the substantial value exchanged and more balanced bargaining power in company or business sales (compared to the employer – employee relationship).

Shareholders’ Agreements

Restraints in shareholders’ agreements usually apply to founders and sometimes key employee shareholders due to their knowledge of the business. The restraints aim to:

prevent restrained shareholders from competing during and after exiting the business
protect confidential information, trade connections, and goodwill, and
provide comfort to investors that key people won’t damage the business on exit.

These restraints typically apply while the person is a shareholder, and often for a specified period after exiting the business (e.g. 12–24 months). Restraints in shareholders’ agreements have not been conclusively tested by New Zealand courts, so enforceability remains more uncertain. But the High Court has held that restraints in shareholders’ agreements (as with all restraints) must focus on a legitimate proprietary interest that requires protection. To maximise enforceability, shareholder restraints should be reasonably scoped and connected to a legitimate interest.

One issue companies and founders should consider is when the restraint period runs from – usually from the date they cease to be either (i) a shareholder or (ii) employed, or engaged as a contractor, by the business. In the NZ context, the restraint period often lands on being the earlier of those two events. Investors might argue that a founder who has ceased to work for a company but who retains a shareholding should not compete. On the other hand, a departing founder has no guarantee of any party acquiring their shares on their exit, so the restraints could continue forever. This is not reasonable, nor likely to be upheld by a court.

Legislative developments and global trends

The Employment Relations (Restraint of Trade) Amendment Bill, currently at its second reading, proposes significant changes to restraints in employment agreements, including:

making non-compete clauses unenforceable against employees earning less than three times the minimum wage
requiring compensation of at least 50% of the average weekly wage during any restraint period

Notably the Bill does not include specific carve-outs for M&A transactions or shareholder restraints, potentially affecting how restraints are structured in all cases going forward. While the Bill focuses on employment agreements, its impact could ripple into other areas, particularly where employee-like roles overlap with shareholder or contractor positions. This is, of course, all yet to be seen with the Bill some way off becoming law (if at all).

There has also been a shift to try and restrict the use of non-competes in places such as the US, the UK and parts of the EU. But, in most cases, those restrictions are not intended to apply to non-competes imposed in connection with M&A deals.

Final thoughts

Restraints of trade are vital for protecting sensitive business interests but must be considered carefully. You should:

ensure there is a specific protectable interest
keep restraints no broader than necessary in activity, geography, and duration
consider the relationship between the parties and the commercial context to assess reasonableness
consider the restraint period, and when it runs from
define the restricted business accurately and fairly in the context of a non-compete.

key issues when structuring ESOPs

Employee share option plans (or ESOPs) are a key tool for Kiwi startups to incentivise staff and hire talent when funds are tight.

We’ve put together this guide to help you consider the key terms of your ESOP. If you want help on the process of adopting your ESOP, granting options and all the necessary approvals, check out our separate guide here.

In this guide, we refer to employees generally as the likely recipients of options. However, options can be granted under an ESOP to anyone providing services to a company, for example, a director or contractor. You just need to make sure you’re applying the right securities law exclusion for the recipient. Our template ESOP rules are flexible enough for a company to use them to make grants to any individuals in those roles.

how big should your option pool be?

Usually an ESOP pool is around 5-15% of a company’s total shares on a fully diluted basis (10% is pretty common). If you are setting up an ESOP as part of a capital raise, your incoming investors may have requirements around the ESOP pool size.

Generally speaking, when you’re raising capital, investors will expect founders and existing shareholders, not the investors themselves, to take on the dilution from an ESOP (i.e. an investor’s agreed stake in the company is calculated on a fully diluted basis, taking the ESOP pool into account even if the ESOP has not been formally put in place at that point).

This means it’s important to ensure your ESOP pool is not significantly larger than required for your foreseeable hiring needs, as that chunk of equity may only be diluting founders and other existing shareholders. Consider the best balance between making sure you’ve set up a big enough pool to attract talent, and avoiding unnecessary dilution.

Your first ESOP pool won’t necessarily be your final ESOP arrangement. As companies grow and go through multiple financing rounds, it is not unusual to see the size of the ESOP increase so key hires can be made during the growth phase.

how much will it cost employees to exercise their options?

The exercise price is the price that an option holder must pay to exercise their options to purchase shares in the company. This is decided on a case-by-case basis for each option holder and set out in individual grant letters.

From a legal perspective, the Companies Act 1993 requires that directors of a company issuing options be comfortable (and resolve and certify) that the exercise price is fair and reasonable to the company and to all existing shareholders. Beyond that, directors of a New Zealand company have broad discretion to set the exercise price.

The exercise price is often fixed at the market value of the company’s shares at the time the options are granted (for example, by reference to the share price in the company’s latest funding round). Employees then benefit as the value of the company increases from the date they receive their options, incentivising them to help grow the company’s value.

However, exercise prices can also be set significantly lower than this market value, where the directors think it’s fair and reasonable to do so.

A company may grant options with a nominal or discounted exercise price to reflect the fact that the employee has worked for the business for some time, and may have been promised options earlier (at a time when the market value was lower).

Some companies and founders prefer to set the exercise price as low as possible. The intention being to give employees the best incentive to help grow the company’s value, because their potential gain on exit starts immediately. It also protects employees if the company hits a rough patch and the market value for its shares at exit, or on exercise, has fallen significantly. You may find investors are resistant to this approach, and it won’t make sense for all companies.

how will the options vest?

Options are only valuable if they can be exercised. To encourage key team members to stay with the company long-term, options generally vest (become exercisable) over an agreed period, typically 3 or 4-years and often with a cliff that requires the employee to stay with the company for 12 months before any options vest. If an option holder leaves before the end of the vesting period, they will usually lose their unvested options.

Our template ESOP rules allow for recipients to have personalised vesting schedules on a case-by-case basis. Where an employee has already worked for the company for a long time before receiving options, a company may recognise that prior contribution by applying a shorter vesting period than would otherwise apply to a new hire, or by applying the same 3 or 4-year vesting period as other ESOP participants, but back-dating the start date of the longstanding employee’s vesting period.

We generally recommend keeping things simple by sticking with time-based vesting. If you do want to have options vest as the employee achieves certain milestones or KPIs, ensure that the thresholds are objective, easily quantifiable, and clearly described in the option documents. Anything less, and you risk misunderstandings leading to disputes between the company and a valued team member.

how long will employees have to exercise their options?

The expiry date of an option is the last date the option holder can exercise that option. This is often aligned with the expected time frame for the company to find an exit, for example, 7-10 years from the date of grant, but of course this depends on the company’s stage and maturity. On the expiry date, unexercised options lapse.

Consider whether the expiry date should be brought forward if the option holder leaves (we discuss this in more detail below). The most employee-friendly ESOP terms do not change the expiry date. This approach gives the option holder the remainder of the expiry period (or until an exit event occurs, whichever comes first) to choose whether or not to exercise their options that vested before they left the company. However, as explained below, a company will often prefer for the expiry date to accelerate if an employee ceases to work for the company.

In New Zealand, tax is a key factor when an option holder is deciding if, and when, they want to exercise their vested options. There is no upfront tax liability when options are first granted to an employee in New Zealand. Typically, an employee will only be required to pay tax when they exercise vested options, at which point they will be taxed, at their marginal tax rate, on the difference between the exercise price and the market value of the underlying shares at that time. So, the longer an employee takes to exercise their vested options, technically the higher the amount of tax payable, assuming the company’s valuation increases. An option holder needs to balance the potential for tax-free capital gain (by exercising their vested options sooner rather than later) against their risk appetite (they may not see a return on the cash they pay to exercise the options and to satisfy their tax bill). For this reason, many employees prefer to hold off on exercising their vested options until an exit event occurs – eliminating downside risk and giving the employee the cash proceeds from the exit event to pay their tax bill. It also explains why employees will generally prefer the expiry date to be as long as possible, and not to accelerate if they leave.

Finally, some companies provide that ESOP options may only be exercised on an exit event. This may be because the founders want to keep the number of shareholders as few as possible but still want to encourage team members to achieve a successful exit. In that case, the company may need to consider how that approach affects other key commercial terms of the ESOP, to ensure the plan is attractive and actually achieves the goal of encouraging people to stay and contribute to the company.

what about leavers?

If an option holder leaves the company for any reason, typically all unvested options as at the leaving date are cancelled without compensation. Most companies follow this approach.

There is more variation between companies when it comes to how an option holder’s departure affects vested options. The approaches tend to fall into two categories – one approach allows the option holder to retain (and exercise) the options that have vested as at the exit date until the expiry date. The other approach requires the option holder to exercise their options within a certain period following their exit date (for example, within the following 3 months), otherwise those vested options lapse. Accelerating the expiry period after an option holder’s departure lowers the company’s administrative burden of keeping track of departed employees who continue to hold unexercised options. Like all of the key ESOP terms, the company needs to balance its own circumstances and concerns against what’s fair and reasonable (and likely to be attractive) for the option holders. If option holders see little chance of ever being able to see a return on their options, a company may find that its ESOP isn’t as successful an incentive as first hoped.

Occasionally, companies also seek a right to repurchase vested options as well from leavers, or even shares that have been issued on exercise of vested options, at an agreed price (which is typically fair market value). This gives the company the flexibility to remove ex-team members as future/existing shareholders and reissue more options to incoming hires out of the overall incentive pool. You’ll see that our template ESOP rules include optional drafting for companies who wish to do this.

Finally we sometimes see bad leaver provisions incorporated. Under these, if an employee leaves in certain limited adverse circumstances (e.g. involving serious misconduct), they may lose all options (whether vested or unvested) for nil.

what happens at an exit event?

This is likely to be the part of your ESOP which requires the most thought. Our template ESOP rules provide for single-trigger acceleration on an exit; that is, all unvested options accelerate and immediately vest on an exit event and can be exercised in full. Single trigger acceleration is the most employee-friendly position and encourages all option holders to work towards an exit as soon as possible.

However, potential buyers of your company can be put off by full single trigger acceleration if they want to retain key employees in the business after the acquisition (and the potential buyer sees the continued vesting of options as a way of encouraging that). For that reason, some companies prefer partial acceleration or double trigger acceleration to make their business as attractive an acquisition target as possible.

We find there is a lot of variation in New Zealand on this point. Single trigger remains the most common, especially compared to the US where double trigger acceleration is more widespread.

The different scenarios are summarised below:

no acceleration	none of the unvested options vest on an exit event, and any unvested options lapse. Option holders can only exercise options which have vested. This is not attractive to option holders and not particularly common.
single trigger acceleration	100% of the unvested options immediately vest on an exit event. This is the best scenario for option holders but increases the chances that key cashed up employees immediately leave following the acquisition.
partial acceleration	a set percentage of the unvested options vest on an exit event. The remaining options continue to vest in accordance with the vesting schedule. This might be a fixed percentage or might sometimes exclude options that have been granted in the last 12 months. It can be preferable to a buyer for employees to remain employed by the surviving entity, so that they continue to work for the business and earn their options. This is clearly less appealing to employees, who could lose unvested options if the buyer terminates their employment after the exit, even if that termination is without cause.
double trigger acceleration	a set percentage of the unvested options vest on an exit event. The remaining options only vest on a second trigger, e.g. the employee being terminated (or resigning with good reason) in connection with, and within a certain time after, the exit event. That way, if the second trigger event does not occur, the employee must stay with the company in order to earn their remaining unvested shares. However, if a buyer does not choose to keep an employee after an exit, the employee is not penalised for this. In New Zealand, we don’t see double trigger acceleration very often but can perhaps expect that to change as some of the larger tech companies start to adopt Silicon Valley practices.

Of course, any scenario that anticipates some form of continued vesting only works if the option plan can somehow survive the liquidity event, or for example the buyer provides an option plan on equivalent economic terms as the option holder has pre-exit.

Finally, it is also worth including provisions in your ESOP rules which can facilitate an exit transaction. For example, give the company’s board of directors the discretion to decide the best structure for dealing with the options, as long as the end result ensures that the option holder still benefits from the exit alongside the company’s shareholders. That may include the company cash settling some or all of the options by paying the holder the difference between the value of the shares on the exit and the exercise price of those options (as opposed to issuing and then transferring the shares). Also, as not all exits are fully satisfied in cash, that may also look like enabling a deal where option holders receive part cash and part shares in the buyer.

round up

In the US, stock option plans have become fairly standardised. Here in New Zealand, despite ESOPs increasingly becoming a common feature of startups, their terms vary much more much according to founder and investor needs. The best advice is to ensure that the board has discretion on certain key terms, particularly dealing with leavers and acceleration. The last thing you want are difficult option holders impeding a potential exit transaction because the ESOP terms are unclear or inflexible.

If you would like to discuss drafting an ESOP for your startup, get in touch.

rolling closes on startup investments

Increasingly, investment documents are incorporating rolling closes. A rolling close mechanism enables a company to complete part of the total investment round with one or more initial investors, whilst leaving the door open for the company to raise further money on the same terms.

pros and cons

Clearly, it is easiest to complete a transaction with all the investors in one single closing. Everyone signs the paperwork at the same time, the company is fully funded and all shares are issued together. But, in the current climate, investors are taking longer to complete their due diligence, and fund. In these situations, a rolling close mechanism allows companies to close some of the round and get cash in the door. Otherwise one small investor can delay the whole round and the company receiving vital cash.

how is it documented?

Typically, the subscription agreement signed by the initial investors will include language relating to the proposed rolling close. This would include a cap on the total amount that can be raised and, normally, a period of time to complete the process. The proposed issue of these additional shares will need to be excluded from certain provisions under the governance documents of the company which either (i) restrict the company from issuing new shares, or (ii) have pre-emptive rights on new share issues.

We have seen rolling closes dealt with in various ways, summarised below:

each rolling close investor signs their own subscription agreement with the company, on the same terms as the initial investors. Of course, this means paperwork is duplicated, taking time to draft. Additionally, the follow-on subscription agreements may need to be tweaked, as most of the closing conditions in the original subscription agreement may have already been satisfied.

each rolling close investor signs a deed of accession to the initial subscription agreement under which they receive the same rights as the initial investors. Subject to ensuring that there is no conflict between the documents, this is efficient and cuts down the paperwork.

occasionally, we have seen a mechanism in the initial subscription agreement enabling rolling close investors to accede to the overall subscription by simply adding their signature to the original document. We think this is not particularly customary and it brings into question the valid date of the document. Therefore, best to avoid.

shareholders’ agreement and constitution

The other issue is the new shareholders’ agreement and constitution. All investors will need to accede to the new shareholders’ agreement on becoming a shareholder, and be happy with the adopted constitution. Whilst small follow-on investors generally invest based on what the lead investor has already negotiated, they may have their own minor requests. Founders will need to manage this process by either pushing back, or potentially agreeing to side letters to avoid amending the main document, which would require everyone to re-sign.

round up

If a rolling close is likely to be required, founders should state this in the term sheet. The lawyers can then ensure the necessary amendments are built into the final investment documents. To cut down on the paperwork and admin, it is strongly recommended that the rolling close investors all complete on a single second completion date, rather than in dribs and drabs.

Finally, to avoid reaching out to shareholders more than once, a good tip is to ensure that your board and shareholder resolutions signed on the initial completion date approve the maximum amount of the capital raise, including the full amount of the rolling close.

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Kindrik Partners is a trading name of the incorporated law firm Kindrik Partners Limited. Kindrik Partners Limited is a limited liability company registered in New Zealand (registered number 6099958) which is authorised and regulated by the New Zealand Law Society.

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