What is a Non-Compete Agreement?
A non-compete agreement is a covenant between an employee and employer that stops the employee from using the the skills and information they learned during employment to enter into competition with the employer. Typically, by signing the non-compete agreement, the employee agrees not to enter into businesses or markets that are in direct or indirect competition with the employer within a specified geographical location and duration.
The goal of the agreement is to ensure that the employer does not invest too much time and money in training the employee, only for that experience and skills to be transferred to a competitor.
In addition, the non-compete agreement prevents the employees from sharing trade secrets like formulas, processes, client lists, and software learned on the job. The agreement limits the employee from using the trade secrets either with another employer or their businesses.
Components of a non-compete agreement
A non-compete agreement for one company may vary from the non-compete agreement of another company since they are prepared specifically for each employer. The typical components of the agreements include:
The duration of a non-compete agreements ranges from six months to two years (or less). An employer can only set realistic timeframes and may not permanently prevent an employee from furthering their careers. Long-term non-compete clauses rarely win in court cases.
The employer must indicate the specific work or activities that they restrict the employee from doing. It prevents ambiguities when it comes to implementing the clause, and it helps the employee know what they can do and not to do to avoid getting on the wrong side of the law.
The geography covers the local area where the company does business, and where the employee should not establish a direct or indirect competing business. The employer may provide a mile radius around the business where an employee may not engage in related business activities for a specified time frame.
The non-compete agreement should specify the type of compensation that the employer should receive if the employee violates the agreement.
Where the non-compete agreement blocks an employee from working with certain competitors, the agreement must define the type of businesses or industries that compete with the employer.
Are non-compete agreements enforceable?
Even though non-compete agreements are widely used by employers, there are discussions on whether non-compete lawsuits would hold up in court. In the past, some courts ruled that such agreements were unfair to the employees since they limit their career advancement. For the court to enforce a non-compete clause, the agreement must be reasonable and fair to the employee.
When the agreement covers a short duration such as six months to one year, and a not-too-large geographical location, the employer may obtain an edge in enforcing it. However, the broader the non-compete agreement is, the less likely that the court will enforce such agreements.
In some states like California, the non-compete agreement is unenforceable against employees. Such agreements are automatically void, except in limited situations that are authorized by statute. The state exercises a strong interest in protecting businesses operating within its jurisdiction so that they can hire employees from within or outside the state. Similarly, in Hawaii, a new law that came into effect in 2015 prohibits high-tech companies from requiring employees to sign non-compete and non-solicit agreements as conditions for employment.
Why employers use non-compete covenants?
The following are some of the situations when an employee may be required by their employer to sign a non-compete agreement:
An employee may be asked to sign an agreement when he/she is leaving the company voluntarily or when the employer decides to end their working relationship. The agreement prevents the employee from competing with the employer by either starting a similar business or working with a competitor in the same market. The pact should stipulate the duration of the contract and outline the type of competitors or companies that the employee should not work with.
When a company hires independent contractors or consultants to address internal company issues, the employer may require them to sign a non-compete covenant. The agreement prevents the contractors from using the company data or trade secrets after the end of the contract.
During the course of their employment at the company, employees often get access to sensitive data or secrets that give the employer an advantage in the market. Some of these secrets may relate to product pricing, formulas, beverage or recipe mixing ratios, ideas, future products and marketing strategies. If the employee uses the information outside the company, they may give competitors of the employer an upper hand in the market, which disadvantages the employer.
In mergers and acquisitions (M&A), it is common for the seller of a business to be required to sign a non-compete as part of their total consideration for the business. The reason for this is that if a company or investor is going to purchase a business, they don’t want the seller to take all the money from the sale and then turn around and start competing with their old business. These types of agreements are generally enforceable by law.
Learn more in CFI’s M&A Financial Modeling Course.
Alternatives to non-compete agreements
Although non-compete agreements are the most common types of restrictive covenants, there are other restrictive covenants used by employers to protect their trade. They include:
A non-solicitation agreement is an agreement that prohibits an employee from soliciting for business from the employer’s customers. After exiting the company, the employee is also prohibited from accepting or discussing business with the employer’s customers.
In addition, the clause prevents the employee from engaging the company’s current employees for the purpose of starting a business that is in direct or indirect competition with the employer’s business.
A non-disclosure agreement is an agreement between two parties that signifies the existence of a confidential relationship between them. When an employee signs a non-disclosure agreement, he/she agrees not to share confidential information that is shared between them and the employer.
The subject of the agreement may be a sales plan, manufacturing process, proprietary software or other sensitive data. A non-disclosure agreement is also referred to as a confidentiality agreement.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: