Think All Noncompetes Stink?

Caggiano, Christopher
October, 1997, page 114
A look at noncompete agreements and some advice on what to do to make sure your agreements can hold legal water.

Business 101

Think again

It's one of those nightmarish scenarios that have robbed many a CEO of sleep: the persistent fear that one of your employees will set up a competing, eating-your-lunch-out-from-under-you shop down the road. But wait. What if you had all your employees sign noncompete agreements? Wouldn't that prevent the worst from happening?

Well...maybe.

Consider the case of Mark Moses. Moses is CEO of Platinum Capital Group Inc., a $7.6-million mortgage-brokering business in Irvine, Calif. In October 1996 a friend who had been doing consulting work for Platinum opened up a rival business less than a mile away. The man also hired away Moses's entire accounting department, most of his sales force, and even his receptionist. Moses hadn't had his friend sign a noncompete agreement, but such an agreement probably wouldn't have been enforceable, anyway. That's because under California law, noncompetes can be enforced only against shareholders of a business--and the erstwhile consultant wasn't one. A preliminary injunction prevented the rival from contacting any more Platinum employees. But Moses couldn't stop the new company from doing business.

Despite their limitations, noncompete agreements have always been an intriguing and hotly contested issue among company owners, particularly in high-tech circles. These days more and more companies of all sizes and in all industries are using noncompetes in an attempt to protect their trade secrets, employee ranks, and customer bases. What's more, in an age of frequent job hopping, company owners are finding that they need to enforce those agreements more often than ever.

According to David Barmak, a lawyer with Sherman Meehan Curtin & Ain, with headquarters in Washington, D.C., both interest in and litigation over noncompete agreements have been increasing recently. Unfortunately, he says, noncompete agreements have proliferated faster than knowledge about them has. Misconceptions abound. "I've even heard lawyers tell people that noncompete agreements are not enforceable," says Barmak. "And that's just wrong." What is true, however, is that a noncompete can be difficult to enforce. To improve your odds, "you have to show it's necessary to protect some legitimate business interest, such as trade secrets," he says.

Even if an agreement is well crafted, it still might not hold up in court. That's because the "reasonableness" of a noncompete resides entirely in the eye of the presiding judge. According to Mel Jager, a lawyer with the Chicago-based law firm Brinks Hofer Gilson & Lione, "courts tend to bend over backward to achieve equity in these cases, because leaving someone without the means to make a living is tantamount to economic capital punishment." Remember, if a judge suspects you're using noncompetes merely to erect competitive barriers, you may be in trouble. Public policy in most states dictates that you can't cause former employees undue hardship and you can't completely prevent them from changing jobs. Location is a critical factor. As Mark Moses is all too aware, states have very different interpretations of what constitutes an acceptable noncompete agreement. As a general rule, the farther west of the Mississippi you go, the harder it is to enforce a noncompete. "That's a cliché, but like all clichés, it's based in truth," says Barmak.

Some argue that noncompetes aren't worth the hassle or the feelings of mistrust they can create. Ken Hendricks, founder and CEO of ABC Supply, in Beloit, Wis., believes that a company that pays competitively and provides a good work environment needn't sweat an employee exodus. "If you have to hold employees by using an agreement, you don't have much in the first place," argues Hendricks, whose $789-million roofing- and siding-wholesaling business is a former #1 Inc. 500 company. Furthermore, if your company can't beat a former employee's start-up, how will you fare against more substantial competition? "Noncompetes are for people who are afraid of their own incompetence," says Hendricks.

Patrick Kelly, CEO of Physician Sales & Service (PSS), headquartered in Jacksonville, Fla., agrees that the best way to hold on to employees is to provide the right culture, which for him means open-book management. "When employees have the opportunity to become invested in the company, noncompete contracts become moot," says Kelly, whose medical-supply business, also a former Inc. 500 company, had $691 million in fiscal 1997 sales. Nonetheless, Kelly uses noncompetes in certain circumstances. He requires selected employees, including officers brought into the company and anyone whom he spends a significant amount of money training, to sign an agreement.

Of course, there's a bit of irony here: PSS might not exist today if Kelly's previous employer had used noncompetes. "Now I'm their worst nightmare," Kelly crows.

Indeed, many of the companies that grace this magazine's pages might not be around were it not for the absence of noncompete agreements. For example, Leza Raffel freely admits that she launched Communication Solutions Group Inc., a $270,000 public-relations agency in Jenkintown, Pa., by walking out of her job and taking three clients with her. To prevent the same thing from happening at her company, Raffel says, she requires every employee to sign a noncompete agreement. But she wouldn't want to do the same. "I would never sign one of those things," she says.

Cut back to Mark Moses. It's January 1997, and Moses believes he's learned his noncompete lesson. He says he has brought in a new management team and has fully recovered from last year's departures. Partly to instill a sense of ownership, he says he's given the four new managers a combined 17.5% of the company. But Moses has another reason, too--and it's the California policy of recognizing noncompetes only for shareholders. Not surprisingly, Moses has included a noncompete clause in the shareholders' agreement that his new managers have signed. And if any shareholder leaves while the company is private, the value of his or her stock will take a 20% "haircut," and Moses can buy back the rest over three years. "I want their heads vested in the long-term future of my company," he says. "We plan to go public soon. This stock will be worth a lot of money some day."

Sure. If they stay.

Christopher Caggiano is a staff writer at Inc.

Jargon: Noncompete-Speak

There's no getting around it: crafting a solid noncompete means working closely with a good lawyer. Here's our translation of some of the most common legal terms you'll encounter:

Noncompete agreement. A noncompete attempts to restrict, for a certain length of time, an employee's ability to leave to work for a competitor, steal your clients, or set up a competing business. You can't completely prevent employees from defecting to--or becoming--the enemy, but you can make them wait for the privilege.

Nonsolicitation agreement. A close relative of the noncompete, this document restricts an employee's ability to pilfer clients or lure away coworkers.

Trade secrets. This term refers to confidential--especially technical--business information. Trade secrets can also include a company's future plans, manufacturing process, or pricing structure. Customer lists are not automatically covered, but the more proprietary information they contain (for example, contact names, price quotes, contract expiration dates), the more likely it is that you'll be able to protect them.

Nondisclosure agreement. This document specifies that your employees will not use your "trade secrets" to benefit anyone but you.

Duty of loyalty. Even without any signed agreements, the law prohibits employees from certain activities while still on your payroll. The law varies from state to state, but forbidden activities can include running a competing business, working for the competition, misappropriating confidential information, soliciting your customers, and recruiting your employees to join a competing firm. Your employees generally can, however, announce their venture publicly (in some states, even using your customer list), lease office space for a new business, and form a corporation.

Now what? Agreements That Stick

No noncompete is ironclad; you'll always be at the mercy of a judge. But there are steps you can take to greatly increase the odds of successfully enforcing an agreement

Research your state's laws. Many states--including California, Florida, and Texas--limit noncompete enforcement. If you're in a state hostile to noncompetes, consider alternatives, too. (See "Noncompete Variations," below.) Otherwise, you may want to specify in your agreement that disputes must be litigated in your home state, to avoid the vicissitudes of trying a case in an unfamiliar judicial environment.

Get specific. Lawyers argue convincingly (if self-servingly) that you can't just copy a boilerplate noncompete clause from a book and expect it to apply to your specific case. According to David Barmak, a lawyer at Sherman Meehan Curtin & Ain, headquartered in Washington, D.C., a one-size-fits-all, lowest-common-denominator approach may be enforceable, "but it probably won't be worth enforcing."

Don't overreach. If you're out to bar employees from any competitive activity beyond your hallowed halls, remember this: the more restrictive the agreement, the harder it normally is to enforce. Mel Jager, a lawyer at Brinks Hofer Gilson & Lione, based in Chicago, recommends that you keep your agreement limited and precise. The time frame should generally be no longer than one to two years. Geographic restrictions should be reasonable, given your industry and the employee's responsibilities (although computers, E-mail, and the Internet have in many situations made geographic restrictions moot).

Give something in exchange. To make a noncompete stick, you have to give the signer something in return. How much is enough? State laws vary considerably, so consult a knowledgeable lawyer. Usually, it's OK to ask new hires to sign a noncompete as a condition of employment. But when you're asking a current employee to sign one retroactively, you may have to cough up something more, such as a promotion or a bonus.

Handle your trade secrets with care. If you want to convince the courts that certain information is a trade secret, you have to treat it as such in your business. Keep confidential information in a secure place, give employees access to it only on a need-to-know basis, and establish a written sign-out procedure. Let your employees know what information is classified; remind departing employees during exit interviews about what they must physically and psychically leave behind.

Check new hires for outstanding agreements. Even if you don't use noncompetes, remember that many companies do. Anil Khosla, a lawyer at Peabody & Arnold, based in Boston, recommends having new employees sign a statement declaring that they are not under a conflicting noncompete clause with another company. If you find out that a recent hire has violated an agreement with another company, he suggests you treat the matter seriously.

Options: Noncompete Variations

Maybe the notion of companywide noncompete agreements leaves you cold or you work in a state hostile to them. You could still...

Target only employees who are shareholders. Judith Nitsch of Judith Nitsch Engineering Inc., a $3.5-million civil-engineering firm in Boston, uses noncompetes only in her shareholders' agreements. In addition, shareholders who are fired or who quit must wait a year before the company will start to buy back their stock. "They can start a competing business, but not with my money," says Nitsch.

Make a noncompete part of a severance deal. If you continue to pay a departing employee for a certain period of time, you may make any accompanying noncompete agreement more enforceable. "You're basically paying a former employee to stay out of the workforce," says Anil Khosla, a lawyer at Peabody & Arnold, based in Boston.

Try another tack entirely. Gary Bitner, president of Bitner.com, a marketing and communications company in Fort Lauderdale, Fla., believes that requiring employees to sign noncompetes sets the wrong tone. "They're hard to make work in Florida, anyway," he says. So as part of his client agreement, Bitner asks customers not to hire or do business with a former employee for a year after the employee leaves.

Resources

For a plain-English primer on employment legal matters, including noncompete agreements, check out The Employer's Legal Handbook 1.2, second edition (Nolo Press, 800-992-6656, 1997, $29.95). Similarly helpful is Stay Out of Court: The Manager's Guide to Preventing Employee Lawsuits, by Rita Risser (Prentice Hall, 800-447-7700, 1993, $19.95).

Sometimes it's useful in a negotiation to know how "the opposition" is thinking. Perks and Parachutes: Negotiating Your Best Possible Employment Deal, from Salary and Bonus to Benefits and Protection, by John J. Tarrant and Paul Fargis (Random House, 800-726-0600, 1997, $25), discusses employment issues from a worker's perspective. It's kind of like having the other side's playbook.