In the Start-Up Entrepreneur Series, I will be taking a deeper look into some of the most common questions early stage founders face in putting together and operating their new businesses.
Last week, we discussed agreements designed to protect a Company’s intellectual property. As part of that discussion, we brought up the concept of “non-competition”; a provision (or set of provisions) designed to prevent a Company employee or contractor from absconding with the Company’s valuable information.
Today we discuss those provisions in more detail.
Non-Competition and Non-Solicitation
Every company has information that it creates, uses, and conveys to its own personnel which it would prefer to keep secret from the outside world: customer lists, that new prototype design, perhaps even manners or methods of employee training. But employees leaving for greener pastures (or “encouraged” to seek those pastures by the Company itself) are a fact of life. How then can the Company protect its valuable information when much of it lives in the minds of its former agents?
The answer, in part, is by asking its employees (and contractors) to enter into agreements that restrain their ability to use that information in a way that negatively impacts the Company. There are three primary provisions that are included in agreements (whether labeled as “Non-Competition” or otherwise) that seek to accomplish this.
A “Non-Competition” provision states simply that an employee (or a founder, officer, manager, or contractor) of the Company is not permitted to “compete” with the Company during the term of his or her relationship with the Company and for some time thereafter. Usually an agreement containing such a provision is made a part of the initial employment (or contracting) package, such that the “giving” of employment by the Company is the “consideration” (i.e., payment) made by the Company in exchange for receiving the non-competition promise.
But different agreements can have very different ideas regarding what it means to “compete” with the Company. If the Company makes hand dryers but the employee seeks to make paper towel dispensers, is that “competing”? What if the employee wants to make hand sanitizers or something else completely? Or if the Company has plans to move into another industry? If the employee knows of those plans? Should a Company operating in Michigan be able to prevent its former employee from competing in California? For how long?
As you can see, there is a spectrum of possible ways to write such a provision, and the way such a provision is written is of the utmost importance, not just to the employee affected, but also to the Company seeking to prevent the competition. That is because as a “restraint” on the trade (i.e., “business”) of the employee, most states look negatively on “non-competition” provisions, even if they were negotiated and executed in good faith by both parties. We’ll discuss that in a bit more detail below, but suffice it to say that both sides must exercise caution in reviewing such provisions.
Non-Solicitation (Customers and Personnel)
The second two provisions most commonly found in a Non-Competition agreement both relate to the employee’s ability to “steal” relationships from the Company. These “non-solicitation” provisions generally state that the employee in question cannot “solicit” (i.e., ask for a relationship with): (i) the Company’s customers and (ii) the Company’s employees or contractors.
These provisions are generally not as contentious as the non-competition provision described above. This is due primarily to the fact that there are clearer “bright lines” at issue here. If a Company has its own customers, then most can agree that its former employee should not be able to use its previous position to steal such customers away. Similarly, a former employee should not be permitted to use the relationships it gained with Company’s personnel (while receiving payment from the Company) to harm the Company thereafter.
There are areas of limited dispute, however, and all should be considered as part of drafting and negotiating a good non-solicitation provision: What if the Company is large and the employee in question never worked with the customer it now wishes to solicit? What if the customer is large and the Company only ever had a relationship with one division which the employee is not now soliciting? What if the employee puts an advertisement on an Internet job board that is responded to by a Company employee?
As ever, answering the foregoing can be a careful balancing act between protecting Company interests and offending the contract offeree.
As mentioned above, it is important to understand that though the Company may have a justifiable reason to have its founders, employees, and consultants execute a non-competition or non-solicitation agreement, they are not looked at fondly by the courts.
Unlike many other contract provisions which are given wide deference (with the courts allowing either side to sign a “bad” deal if it was properly negotiated), most treat non-competition restrictions as inherently bad due to the limitations they place on individuals who might otherwise just be seeking to make a living. In other words, if a non-competition provision prevents a trained programmer from actually programming anything anywhere, you can bet that it will, at minimum, be reduced in scope if not voided outright.
In general, there are a few ways these provisions get into enforcement trouble:
They apply to too large of a geography
If a Company is not operating in a given place, then the courts are reluctant to tell an employee that they may not operate in that place (since the Company has “no” interest there). The rise of Internet-based businesses has made this entire line of discussion even more difficult, however, given the courts’ general reluctance to have non-competition provisions apply worldwide, even if the Company may justifiably claim a worldwide presence or market.
They apply to low-level employees
No matter how important McDonald’s thinks the Big Mac’s secret sauce recipe is, a court will not generally allow a company to enforce non-competition provisions on minimum wage or low skilled workers. The damage done to them by preventing them from earning a livelihood is, in most instances, simply deemed too great. That is one reason why companies must take special care to make sure that information that might otherwise be considered a trade secret is not disseminated below management level personnel.
They restrict trade for too long
The Michigan rule is that a non-competition provision narrowly tailored to a Company’s industry and geography and protecting a valid proprietary interest is generally permitted to survive for about 2 years after the relationship between the Company and the affected employee has ended. Anything more is likely to get struck down by the courts as unnecessary.
Note, however, that non-competition provisions associated with the selling of a company are usually permitted to apply for a longer period (generally about five years). That is because the courts see a benefit in helping ensure that acquirers realize the value of their acquisition. (“Buying” a company would mean very little if the founders were permitted to start-up a competitor on Day 1.)
They apply in California
Though not the only state outright hostile to the “non-competition” provision, California is by far the most famous. Outside of special circumstances (such as the equity sales described above) California holds all non-competition provisions unenforceable. This stance has given rise to some of the regular tumult and job-swapping you see in places like Silicon Valley, and provides ample reason for any IP-based company to use caution when operating in the state.
Non-competition and non-solicitation provisions require Founders and counsel alike to have a good handle both on what the Company is most interested in protecting, as well as on how best to approach employees and potential employees with the terms it seeks to request of them. Because of regular questions of enforceability surrounding the provisions, it helps to have the restrictions as narrowly tailored as possible, while still protecting the Company and its interests.
As always, if you have any insights on today’s post or would simply like to discuss further, please leave a comment down below or contact me at firstname.lastname@example.org. I’d love to hear your thoughts.