Non-Compete Clause

What is a non-compete clause?

Non-compete clause (German: Wettbewerbsverbot or Wettbewerbsklausel) is, in company and transaction law, the clause by which shareholders or sellers of a business undertake not to compete with it. The ban applies for a certain time, for certain products and services and for a certain territory. It protects the value that co-shareholders or an acquirer finance: customer relationships, know-how and market position. Anyone who buys a business wants to prevent the seller from reopening the same business next door the following day and taking the customers along.

The clause appears in two places. In the shareholders' agreement of a funding round, the contract among all shareholders alongside the articles of association, it binds founders and active shareholders for the duration of their shareholding and for a period afterwards. In the company purchase agreement, it binds the sellers from closing, that is, from the day on which the shares pass to the acquirer. Post-contractual bans for employees and managing directors arising from their service relationship follow their own rules (non-compete agreement). If a founder is both shareholder and managing director, both bans apply side by side.

Non-competes among shareholders

The German Limited Liability Companies Act (GmbHG) contains no statutory non-compete for shareholders. At most for shareholders with controlling influence, a ban is derived from the corporate duty of loyalty, the duty to take the company's interests into account. In growth companies, it is therefore expressly regulated in the shareholders' agreement, usually for the founders and other active shareholders. A common arrangement binds them for the duration of the shareholding and for 1 to 2 years after leaving.

Financial investors are regularly exempt. Funds for venture capital hold stakes in several companies in the same market and instead assume confidentiality obligations regarding the information they receive as shareholders. A founder's breach of the non-compete is often provided for in shareholders' agreements as a ground for classification as a bad leaver. The articles of association often additionally provide for it as a ground for compulsory redemption (Einziehung), so that the share can be redeemed against compensation.

Competition law limits on non-competes

Shareholders

Non-competes are agreements that restrict competition. They must therefore be measured against the prohibition of cartels in Section 1 of the German Act against Restraints of Competition (Gesetz gegen Wettbewerbsbeschränkungen, GWB). Where there is a cross-border effect, European competition law also applies (Article 101 of the Treaty on the Functioning of the European Union). They are permissible to the extent that they are necessary to protect the company in its existence and functioning. This supports a ban for shareholders who have influence over management or access to essential know-how. For pure capital providers without such influence, a ban is hard to justify. Post-contractual bans after leaving are additionally subject to the prohibition of agreements contrary to public policy (Section 138 of the German Civil Code, Bürgerliches Gesetzbuch, BGB); case law generally does not regard more than two years as appropriate.

Sellers

In a company purchase, a ban is permissible as a necessary ancillary restraint, that is, as a restriction without which the purchase would fail its purpose. This is the case where it protects the acquirer from the seller immediately using the transferred goodwill (goodwill) and know-how for itself again. Goodwill includes, for example, the customer base and reputation. Under the European Commission's notice on ancillary restraints, which German practice also follows, the following applies:

• Time: up to two years if only goodwill is transferred, up to three years if know-how is also transferred.
• Subject matter: only the products and services that the business sold offers at the time of transfer or has concretely planned.
• Territory: only the area in which the business offered these services before the transfer.
• Persons: the seller and the companies affiliated with it; pure financial holdings without influence on management may not be prohibited.

Insofar as a ban exceeds these limits, it is invalid. In individual cases, case law has shortened terms that were too long to the permissible extent; with a ban that is too broad in subject matter or territory, this possibility generally does not exist. A severability clause does not replace careful limitation.

Consideration and tax treatment

Unlike for employees, no non-compete compensation is required for a seller's ban. The ban is part of the performance for which the acquirer pays the purchase price and is generally not remunerated separately. If a separate payment is nevertheless agreed or if the ban has independent economic significance, that payment may be treated differently for tax purposes than the disposal gain. For private individuals, other income under Section 22 no. 3 of the German Income Tax Act (Einkommensteuergesetz, EStG) may then come into consideration, which is fully taxable, instead of the partial income method (Teileinkünfteverfahren), under which only 60% of the gain is taxed. For a selling holding company, the extensive tax exemption under Section 8b of the German Corporation Tax Act (Körperschaftsteuergesetz, KStG) falls away to that extent. The split between purchase price and payment for the ban therefore belongs in the sellers' tax review before signing.

Structuring a non-compete clause

• Definition of competing activity: usually covers direct and indirect activities, as entrepreneur, shareholder, adviser or employee. The wording should expressly permit activities outside the protected area.
• Exception for financial holdings: it is customary to exempt holdings in listed companies up to a low threshold, without an organ function.
• Start of the period: in the purchase agreement, as a rule the closing day; in the shareholders' agreement, leaving as a shareholder.
• Sanctions: a claim to desist, damages and a contractual penalty per breach, because a loss from competition can rarely be quantified precisely.
• Supplementary clauses: bans on poaching employees and customers (non-solicitation clause) and confidentiality obligations, which are assessed similarly under competition law.

Practical example: non-compete clause on the sale of a software GmbH

Two founders sell all the shares in a warehouse logistics software company to a strategic acquirer by way of a share deal. Both remain managing directors for 12 months in order to hand over customers and development knowledge. The acquirer's first draft contract prohibits them from any activity in the software industry worldwide for five years.

In negotiation, the ban is brought back to the extent that the acquirer actually pays for. It covers software for warehouse management and route planning as offered on the closing day, in the countries with existing customers. The term is three years from closing, because the founders' know-how passes with the business. Excluded are holdings in listed companies of up to 3% and investments as business angels in companies outside the protected area. The contractual penalty is set per breach. The ban in the managing director's contract is drafted so that it covers the same activities and does not extend beyond the seller's ban.

The result is a narrower but robust ban. The acquirer obtains protection that withstands competition law scrutiny, instead of a broad ban that could fall away in whole or in part in a dispute. The founders retain room for later activity outside the business sold.

Distinction: non-compete clause, non-compete agreement and non-solicitation

• Non-compete agreement: post-contractual non-compete arising from an employment or service relationship. For employees, Sections 74 et seq. of the German Commercial Code (Handelsgesetzbuch, HGB) apply, with non-compete compensation and a maximum term of two years.
• Non-solicitation clause: does not prohibit competition as a whole but only the targeted poaching of employees or customers. It is the milder means and is often agreed in addition.
• Confidentiality undertaking: protects information, not markets. For financial investors, it is often the only restriction.

Common mistakes

• Industry term instead of business field. A ban on "software" or "technology" goes beyond what the acquirer paid for and is open to challenge under competition law.
• Worldwide scope without a market link. Territorially, only the area in which the company was active deserves protection.
• Term above the competition law limit. Terms of five years and more can be justified in a company purchase only in exceptional cases.
• Financial investors included. A ban on capital providers without influence on management is hard to justify and is regularly rejected by investors.
• No exception for financial holdings. Without one, even holding a fund or share interest in a competitor breaches the ban.
• Separate payment without tax review. A stated price for the ban can change the tax treatment of part of the proceeds.

Frequently asked questions

How long may a non-compete for the seller of a business last?

As a rule up to two years, and up to three years where know-how is transferred, from closing. Longer terms can be justified under competition law only in special circumstances.

Must a seller be paid separately for a non-compete?

No. Unlike for employees, no non-compete compensation is prescribed. The ban is economically included in the purchase price; a separate payment is the exception.

Do venture capital investors sign a non-compete?

As a rule not. They invest in several companies in the same market and undertake confidentiality instead. Non-competes in the shareholders' agreement therefore usually apply only to founders and active shareholders.

What follows from a breach of the non-compete?

The beneficiary can demand that the breach cease, claim an agreed contractual penalty and demand damages. In a shareholders' agreement, a breach often additionally leads to redemption of the shares or classification as a bad leaver.

How is a non-compete clause typically worded?

It names the persons bound, the term, the protected activity and the territory, together with the exception for pure financial holdings and a contractual penalty per breach. In a purchase agreement, the core reads in substance: "The seller shall not, for two years from the closing date, be active, directly or indirectly, in the company's field of business in the countries in which it generates revenue on the closing date."

Does a non-compete apply to GmbH shareholders even without an agreement?

In principle no. The GmbHG contains no corresponding rule. Only for shareholders with controlling influence can a ban arise from the duty of loyalty, the scope of which must be determined in the individual case.

The Roemer Capital view

In sell-side mandates, Roemer Capital treats the non-compete as part of the overall economic package. Scope and term depend on what an acquirer actually pays for and what activity the founders plan after the sale. Roemer Capital clarifies these plans early, so that the key points of the ban are already in the letter of intent (LOI) and are not first negotiated in the draft purchase agreement.

The competition law and tax assessment, in particular of a separate payment, is a matter for the sellers' law firm and tax adviser. Roemer Capital prepares the negotiating positions so that the ban, the managing director role after closing and the components of the purchase price fit together.