Let's say you just accepted my job offer to join my small business and it is your first day on the job. You walk in and I greet you this way. What would you do?
Welcome to StraussCo! We are happy to have you join our small business family and are confident you will just adore working here.
Before you start, we need to handle some nuts-and-bolts. Please make sure you sign your employment contract, and review our healthcare plan. Unfortunately, no, we are not dog friendly—I'm allergic!
We also need to you to sign our standard non-compete agreement. Undoubtedly, your former employer had you sign something similar. We need this because during your employment here, you will be learning information about StraussCo that may include confidential intellectual property, proprietary information, trade secrets, and so on, and we need to protect those.
Your non-compete includes the following provisions:
After leaving your employment with StraussCo (for whatever reason)
- You cannot work for any competitor of ours for four years;
- You cannot work for any competitor within a 1,000-mile radius of our home office for four years;
- You cannot work in any industry related to our field for two years.
We think these are completely reasonable requests and hope you agree. Thanks, and once you sign the non-compete, welcome to the family!
After first throwing up in your mouth a little bit, you might be wondering if such a non-compete agreement is even legal and enforceable.
Let’s find out why.
Non-Compete Agreements Generally
It is not hard to understand why you would want an employee to sign a non-compete agreement. After all, it is often the case that when someone works for a small business, they come into contact with proprietary, confidential information about the company; its “secret sauce” if you will.
That secret sauce could be financial information, customer lists, intellectual property, supplier details, marketing strategies, business plans, whatever. A business, and a small business especially, has every reason and right to want to protect this type of information; competition is real and information is valuable. One way, therefore, that businesses protect their secret sauce is by not having former employees share it with competitors and they do that by restricting that former employee's ability to work with those competitors.
Hence, the “non-compete agreement.”
The other reason small businesses like non-competes is that they do not want to lose talent to the competition—talent you often spent considerable time, money, and resources teaching and grooming. Imagine drafting Stephan Curry only to lose him to a rival team after Curry’s rookie contract ran out. Who wouldn’t want to prevent a Curry-like talent from jumping to a new company?
So you can undoubtedly already see the tension inherent in such an agreement within employment law. While yes, you may have valid reasons for your non-compete, the employee has an equally—if not more—valid reason to want to seek work in their industry, given their experience, contacts, skills, and so on.
So What Exactly Is in a Non-Compete Agreement?
A non-compete agreement is a contractual arrangement between, typically, an employer and an employee (although it could also be between a business seller and buyer, or other entities altogether). The contract sets forth specific future restrictions on the signer’s ability to seek and work for competitors of the business. It will state that the signer agrees to not to work for the competition in a certain geographic scope for a set amount of time. It may further state that the signer cannot share certain confidential information without consent, i.e., a non-disclosure clause.
A typical non-compete clause or agreement might look like this:
During my employment with the Company and for a period of ________ (months/years) after my employment is terminated by the Company or by me for any reason, with or without cause, I will not, in _________ (define geographic territory), engage in or own or control any interest in, or act as an officer, director, or employee of or consultant or adviser to, any firm, corporation, or institution directly or indirectly in competition with, or engaged in a business substantially similar to, that of the Company.
Each state has its own state laws as to whether non-compete agreements are legal, and if they are, whether they protect legitimate business interests, whether they restrict unfair competition, and what the limits are on their enforceability. The reason states laws and courts (often supreme courts) weigh in on these contracts is that there are clear public policy issues that arise with them, including what is called potential “restraint of trade.” Courts are generally loathe to prohibit people’s ability to seek work, start a business, and so on. Accordingly, non-competes are considered “restrictive covenants” that are often viewed as antithetical to our capitalist way of life.
Thus, for example, California essentially forbids all non-compete agreements. Conversely, In Arizona, non-competes are generally enforceable, as long as they are not broader than necessary to protect a legitimate interest of the employer and are not unreasonably restrictive (in both time and scope) for the employee. They also must not be against public policy. (You can see a list of which states allow what here.)
This split of opinion in states reflects the fact that there are pros and cons to such employment agreements dictating what happens when an employee leaves.
For starters, non-competes incentivize small businesses to invest in their teams. They improve the employment relationship (and even that with an independent contractor). Training, commitment, culture and more are all made stronger when a business and the founder/CEO/entrepreneur are confident that it is worth their while to invest in the business' employees, that the work and effort won’t be for naught. Stronger teams bring up the quality of work all around and help strengthen customer relationships. On a more basic level, you want to know that you have a protectable interest, that you can trust your staff—that they won’t just traipse off with valuable code, lists, or skills, upon either the employee quitting or the termination of employment.
Conversely, non-competes are, by their very nature, restraints on trade. They limit freedom of movement and prevent workers from finding work in which they are most trained and experienced.
Additionally, given that many of these agreements limit an ex-employee’s ability to even start their own business, it is argued that they stifle innovation and entrepreneurship.
Certainly it is understandable why you would seek to limit the future work prospects of an executive, manager, engineer, or professional—after all, these are the types of workers who are most likely to be in contact with confidential information or processes. What is much less clear is why a company would seek a non-competition agreement with, say, a camp counselor (as reported in the New York Times).
That S’more recipe must be very special!
Are Non-Compete Agreements Legally Binding?
To ensure the enforceability of non-compete agreements, the agreement must contain at least the following:
- Effective date
- Reason for the agreement
- Specific length of time the (ex) employee will be limited in work scope
- Specific geographical reason where the employee cannot work
While each state looks upon these agreements differently, it can nevertheless be said that there are some broad, general areas of agreement that constitute an enforceable non-compete. Essentially, there are four factors that go into the analysis. Whether a state like Illinois or Oregon does or does not look upon them kindly depends on how it weighs each of these factors.
1. Geographical Restrictions
It is usually the case that a non-compete will include a geographical restriction, limiting the signatory’s ability to seek work in a defined region.
For example, let’s say that a restaurant owner wants to sell her successful cafe. The buyer may want to include a non-compete forbidding the owner from opening up a new restaurant in the same city, given that the old owner would likely be able to take customers away from the new owner.
This is the type of geographic restriction that is likely to pass legal muster because it makes sense, is intended to help the new owner rather than penalize the original entrepreneur, and the geographic area is “reasonable.” On the other hand, a restriction stating that the old owner cannot open a restaurant in the whole state would not fly because the geographic region is too broad.
What is “reasonable”? Aside from being the type of seemingly mundane thing that lawyers get paid big bucks to fight over, the basic rule is that specific, limited limits will typically fly in those states that allow such agreements.
2. Timeframe Restrictions
Aside from place, the period of time that someone is prevented from applying their trade is the other big issue that courts most often grapple with. Generally speaking, the longer the limit, the less likely it is to be enforceable. And again, the question is, what is the reasonableness of the restriction upon the employee and the potential new employer?
Needless to say, the answer must be applied on a case-by-case basis. A restauranteur involved in the sale of a business may reasonably be limited for, say, a year, as that will give the new owner a chance to get on his feet. But a coder in a high-tech business may reasonably be exempted from finding work with a competitor for maybe two years. It all depends.
According to the legal website Nolo.com, The shorter the agreement, the more likely a court is to find it reasonable. Although there's no clear-cut rule, agreements that last for a year or two are more likely to be upheld than agreements that extend well into the future.
3. Type of Work, Industry
In highly competitive industries (say technology or media), these agreements are much more common, and allowable, but again, only if they are limited. Here is how Nolo puts it: Employers are more likely to win in court if they prohibit an employee from working for a short list of direct competitors, or prohibit the employee from starting a new business in the precise field the employer occupies.
That said, the typical small business is not all that often engaged in the type of commerce that would normally require a strict non-compete clause. On the other hand, it may be that a small company has one very specific competitor. As such, it would have a very good reason for wanting a non-compete, given that it does not want that competitor to pilfer its employees.
4. Narrowness or Expansiveness of the Contract
All in all, as we have seen so far, the key to having a non-compete that passes legal muster is that it be limited to the extent possible. Overly broad agreements are the ones that courts frown upon the most. If the geographic region is too broad, if the time of restriction is too long, if the list of possible new jobs or "competitors" is vast, the agreement is probably unenforceable.
Here is an example: Allied Fire Protection v. Huy Thai. Allied Fire Protection consults on, designs and installs fire prevention systems, like fire alarms and sprinklers, for buildings. They hired Thai as a top manager. Thai signed a non-compete stating that, for five years after his employment ended, Thai would not:
1. Provide or engage in any way business of a similar nature to the business of the Plaintiff without written consent of the Plaintiff.
2. Directly or indirectly engage in any similar business (i.e., engineering, consulting and general construction) with Plaintiff’s former, current or future clients for Sixty (60) months after separation from Plaintiff’s business.
After his job ended, Thai went to work for a client of Allied. Allied sued, attempting to enforce the agreement. The U.S. District Court in Maryland ruled that the agreement was unencodable for several reasons:
- First of all, the agreement “…restricted the employee’s ability to engage directly or indirectly in any type of engineering, consulting or general construction business anywhere within Maryland or for that matter, the world.”
- The agreement was far too broad; to be enforceable, it needed to be “narrowly tailored.”
- The timeframe was far too lengthy. Five years was ruled to be unreasonable, especially as the employer had no proof as to why such a long timeframe was needed.
- Finally, the agreement violated Maryland’s public interest as it prevented a capable worker from working.
Tips for Small Business Employers
Employers that do have reasonable explanations for asking employees to sign non-competes should do a few things in order to be assured that the agreement will be considered enforceable.
First, have the agreement be part of the offer letter to the employee. That way, he or she understands that it is a requirement of the job.
Needless to say, the agreement should be narrowly and specifically tailored to this employee and this job. A “one size fits all” agreement is ripe for problems. That non-compete agreement that you found online used by a tech company for its engineers would be inapplicable to your sales manager.
Additionally, the agreement should be in alignment with the state where the worker will work. Hiring people in Ohio, and having them sign a non-compete, and then transferring them to California would likely nullify any agreement.
Finally, of course, limit the time and geography in the agreement.
So, Is It Enforceable?
The non-compete I asked you to sign the top of this article listed three restrictions:
1. No working for any competitor for four years. Four years, as you may now surmise, is likely too long.
2. No working for any competitor with a 1,000-mile radius of the home office. Again, likely too broad; too vast an area, especially if my small business is quite local.
3. No working in any related industry for two years. While two years may be reasonable, “any related industry” is not.
So, now that you know how to make your non-compete enforceable, you are—as Jodie Foster said in the movie Contact as she was headed into interstellar space—“OK to go!”