The ABC’s of Non-Competition Agreements

Employers commonly use non-competition agreements with key employees, to protect the employer against a former employee using the employer’s specialized training, trade secrets, or other confidential information against it. There are pitfalls, however, that may lead to the non-compete being unenforceable, or at least severely trimmed back. In some states, moreover, non-compete agreements are simply illegal.A non-compete agreement typically does one or more of the following:

1.     Prohibits a former employee from competing with the employer following the end of the employment;

2.     Prohibits a former employee from soliciting clients or customers of the employer following the end of employment;

3.     Prohibits a former employee from soliciting employees of the employer following the end of employment.

California and North Dakota are the most restrictive states with respect to non-compete agreements. If an employer tries to enter into a non-compete with employees in those states, the agreement will be void and unenforceable. This approach is based upon public policy that favors open competition and employee mobility. There are only three narrow, statutory exemptions to this rule. Non-compete agreements will be permitted in the context of the sale of a business, the dissolution of a partnership, or the sale of an LLC. However, even in such cases, the non-compete is only permitted for the seller (or departing partner), and not for employees in general.

While you might assume that California is the pioneer in this area, the North Dakota law is actually older than California’s law. North Dakota adopted its ban on non-competes in 1865, while California adopted its version in 1872.

There is a growing body of opinion and scholarship supporting the notion that non-competition agreements hold back the economy.

“Noncompetes are a dampener on innovation and economic development,” said Paul Maeder, co-founder and general partner of Highland Capital Partners, a venture capital firm with offices in both Boston and Silicon Valley. “They result in a lot of stillbirths of entrepreneurship — someone who wants to start a company, but can’t because of a noncompete.”    

Based on those concerns, Massachusetts Governor Deval Patrick has introduced legislation banning non-compete agreements in Massachusetts. The proposed bill is currently working its way through the legislative process, and if it passes, Massachusetts will join California and North Dakota in prohibiting almost all non-competes.

Outside of California and North Dakota, non-compete agreements are generally considered valid, as long as a few basic requirements are met. First, the non-compete must have a legitimate business purpose. Second, the non-compete has to be narrowly tailored to achieve that purpose. Third, the non-compete must be reasonable in terms of duration and geographic scope. Even though non-competition agreements are valid in these other states, courts generally view them with disfavor, recognizing that they are restraints of trade and typically favor employers.

If you are going to use a non-compete agreement, you should do the following to increase its chances of being enforceable:

1.     Define the business interest you are trying to protect. To do this, you need to identify some advantage that your business possesses, which if used by a departing employee, would make it unfair for that employee to compete with you. This advantage could include goodwill, trade secrets, or relationships with customers, among others. This general requirement, however, necessitates that any non-compete agreement be individualized to the specific employee and his or her role in the company. One size doesn’t really fit all.

2.     Keep the term short. Your initial inclination may be to set a term of three years, or even five years. Doing so will almost certainly guarantee that any court will drastically trim back the term of the non-compete. The idea is to tailor the term to preserving your competitive advantage, for example by giving you a head start on locking down key business relationships. If you can’t do that in six months, you won’t be able to do it in three years, either.

3.     Keep the geographic area narrow. Defining an enforceable geographic area will necessarily depend on the nature of your business. A restaurant serves a much narrower geographic area than a company selling products throughout the US. Even so, if the geographic area of the non-compete has the effect of preventing a former employee from working at all, there is a strong risk that a court will cut back the scope of the agreement.

4.     Be specific as to the prohibited activity. A non-compete agreement should clearly define the activity that is covered. If the departing employee worked as a sales manager, then it is better to restrict her from acting in a sales function, rather than restricting her from “working in any capacity for a company in competition” with your business.

If you keep these considerations in mind and follow these basic guidelines, there is a greater likelihood that your business’s non-competition agreements will be valid and enforceable.Follow me on Twitter @PaulHSpitz