Imagine you’re a private equity firm. You buy a company, and you want to retain and incentivize key employees, so you give them some equity in the form of incentive units. You also want to prevent them from running off and competing against you, so you impose restrictive covenants on them with a forfeiture provision. The deal is simple: “Here’s some stock, but don’t solicit our customers or employees or we take back the stock.”
Now, what if a key employee leaves and solicits your customers? Per the agreement, you may take back the stock. But if you do, may you still enforce the restrictive covenants and prevent the employee from competing?
According to the Delaware Court of Chancery, the answer is no.
In North American Fire Ultimate Holdings, LP v. Alan Doorly, the court ruled that restrictive covenants tied to incentive units became unenforceable once those units were forfeited. The reasoning is straightforward: promises or agreements require consideration – something of value – to be enforceable. If the only consideration for the restrictive covenants was the incentive units, and those units vanished, then the covenants vanish too.
The employee in this case argued that once his units were forfeited, the restrictive covenants had no legal foundation. The court agreed, emphasizing that contracts need valid consideration to be enforceable.
This seems like an intuitive ruling. You offer stock to an employee in exchange for a promise not to compete. If the employee then breaches his commitment, you could take back the stock (as per the agreement), but you can then no longer enforce the non-compete because the stock was how you got the employee to make the promise in the first place.
Why This Matters
For employers, this is a wake-up call. If you want restrictive covenants to stick, you need to offer something extra that doesn’t disappear the moment you decide the employee violated those covenants. A promotion, a bonus, a salary increase – something tangible. Otherwise, you might find yourself in court, watching your non-compete clauses evaporate. The court in this case noted there is no allegation that the employee received a promotion, increased compensation, expanded responsibilities or enhanced access to company information in exchange for signing the agreement.
This ruling sends a clear message to employers that restrictive covenants must be backed by meaningful and lasting consideration.
Here are four key takeaways:
First, restrictive covenants must have permanent consideration. Employers can no longer rely solely on incentive units as the foundation for non-compete or non-solicitation agreements. If those units are forfeitable and can be taken away, the restrictive covenants may evaporate too.
Second, agreements need separate, durable consideration. To enforce restrictive covenants, companies should provide something enduring, like a salary increase, a cash bonus or ongoing access to proprietary company resources. These ensure the agreement remains valid even if equity-based incentives are forfeited.
Third, employees may challenge these covenants more often. Employees who signed restrictive covenants tied to forfeitable incentive units may now be more inclined to argue that those agreements should be unenforceable. Employers should expect more litigation around non-compete clauses.
And fourth, employers should reevaluate existing employment contracts. Firms that structure compensation around incentive units should revisit their contracts to ensure restrictive covenants are backed by adequate legal consideration. If they fail to do so, they risk compromising their ability to prevent departing employees from competing against them or poaching key staff.
Significant Implications for the Tech Industry
The ruling in North American Fire Ultimate Holdings, LP v. Alan Doorly has significant implications for the tech industry, where equity-based compensation and restrictive covenants are common.
Tech professionals often switch jobs frequently, and this ruling may make it easier for employees to challenge restrictive covenants tied to forfeitable equity. This could accelerate talent movement, allowing engineers, designers and executives to transition between companies more freely.
It also may trigger a shift away from equity-based consideration. Tech firms may start offering more traditional forms of consideration – like retention bonuses, salary bumps or access to proprietary tools – to reinforce their agreements. While stock options remain attractive, they might not be enough to sustain enforceable restrictions.
Private equity-backed tech firms may be especially vulnerable. Many private equity investors acquire tech companies and implement restrictive covenants for executives and key employees. Those agreements often hinge on forfeitable equity, making them more susceptible to legal challenges post-Doorly.
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