Overview of Non-compete Clauses
At Chapman and Company, we often have clients who come up against challenges related to non-compete clauses. Non-compete agreements are common contracts that affect the business community, and many individuals do not know what they are and how they work. This post is intended to provide a high-level review of non-compete clauses. It is not a legal opinion or advice.
Non-compete agreements and other employment clauses sometimes have a chilling effect on people who may want to start a company or join a start-up. Thus, understanding these agreements may help entrepreneurs and start-ups increase innovation and productivity in Nebraska. In addition, it may be helpful for new startups to understand some basics with respect to non-compete clauses.
What is a non-compete clause, and how are they used?
A non-compete clause (NCC), sometimes called a covenant not to compete, is a legally binding agreement by an employee not to work in or start a similar company in competition with an employer. This basically means that an employee who signed a non-compete agreement cannot start a company, or quit and then take a similar job at a competitor for a period of time. Generally, this period of time is measured against the type of agreement and the public policy associated with the specific facts of the case. For example, a permanent non-compete is against public policy because it prevents the person from being able to work in his or her chosen industry.
Here is a scenario that may help illustrate how non-compete agreements are beneficial, but also how they may chill a potential start-up. Let’s suppose that Jane works for ‘Dog Houses’ in Omaha, Nebraska. Dog Houses builds houses for dogs with automated heating, cooling, and lighting systems. Dog Houses asks Jane to agree that if she quits, she will not then go work for Dog Houses’ competitors for a limited period of time, and within a certain narrow geographic boundary. These restrictions are likely enforceable.
The public policy behind these agreements are based on an effort by the government to ensure that companies can create new products and services and remain protected from competition that could be deemed unfair. In this specific example, Jane’s boss at Dog Houses asks Jane to sign this non-compete agreement because Dog Houses does not want Jane to share Dog Houses’ secret technology with a competitor. Jane signs, promising that she will not work for a competitor or start a similar company within a 50 mile radius of Omaha for one year after she quits Dog Houses. Because Jane signed the NCC, she is restricted from working for a competitor.
Employers such as Dog Houses use these clauses often because they have information (sometimes called a “special sauce” in trade terms) about their business that they want to protect from exploitation. The kind of information that employers do not want former employees like Jane to pass along to their competitors may include trade secrets, customer lists, and product information. Not having to build the systems and know-how gives competitors an advantage. This advantage is driven through cost benefits and other potential efficiency gains.
Jane is also prevented from starting a new business for one year, and within 50 miles from Omaha. The rationale for this clause is the same as it is for not becoming an employee of a competitor. This non-compete agreement helps Dog Houses protect its confidential information from being used by competitors. But there are additional public policy issues associated with adding a competitor (Jane’s new company) in the market. For example, imagine if Jane had been a co-founder of Dog Houses and her partner bought her out with the promise that she would not compete. Now, the public policy is even more heavily aligned with Dog Houses because there is clear consideration (money) given to Jane with the expectation that she will not compete.
In many instances, some non-competition protection for the employer is justified. In the imaginary example above, Dog Houses has developed a great product, sales process, etc. Dog Houses had to spend its own money and potentially investors’ money to create this proprietary information and business. Imagine now that Jane quits six months in at Dog Houses to start the Dog Domicile Company, and then replicates the same technology, product, and services, takes the customer list, and offers a slight decrease in price. This seems unfair, does it not? This is the reason that non-compete clauses exist. States and governments want to encourage companies and people to come up with new ideas, innovations, products, services, and companies, without having to worry that employees will walk away with all their information and put them out of business.
Are non-compete agreements enforceable? Often, the answer is no. The primary reason is that companies attempt to overreach. They make it impossible for a person to reasonably comply. Such over-broad agreements may prevent a person from ever starting a company or working anywhere in the same industry. It would be bad public policy for the State to enforce overly broad non-compete agreements that essentially force a trained and qualified person, such as Jane, to choose a new career.
In this case, creating an environment where Jane has the freedom to change jobs and find new employment or start her own company is in the best interest of the State; therefore, non-compete agreements cannot be unreasonable (a technical term, explained in the next section).
Imagine that instead of a one-year and 50 mile radius non-compete clause, Jane’s boss had asked her to sign a non-compete agreement that restricted her from working for a competitor for say, five years, or from working for a competitor anywhere in the U.S. This would likely be considered an unenforceable non-compete agreement in Nebraska for the reasons above.
NCCs are governed by individual states. Like most contract law, state law dictates the rules. This is important for at least two reasons. First, Nebraska has different rules than other states – and they are generally pro-employee. Second, an employer cannot invoke another state’s rules simply because an employer prefers the other state’s rules. Thus, the NCC rules in this particular post are specific to Nebraska.
What is the public policy related to these clauses?
Employers sometimes want to restrict former employees from working with the former employer’s customers for several years, or from working within a very large geographic area. (As contrasted in the two imaginary scenarios discussed above). However, it is good public policy to allow employers to protect their information, while at the same time allowing former employees to go out and earn a living as they leave and start new jobs or their own companies. It is important to understand these time and geographic restrictions, whether as the drafter or the signer of the agreement.
Here are a few rules of thumb:
1. The key to a non-complete clause is that it must have a reasonable time limit – one year is reasonable. More than two years is probably not reasonable. Five years is definitely not reasonable for an employee – but possibly it would be for a co-founder who was bought out.
2. Non-compete clauses must also be reasonable in their geographic limitations. In other words, a clause that restricts an employee from working for competitors anywhere on the North American continent is almost certainly not reasonable, and a court would not enforce that clause. Some geographic restrictions are reasonable. Restrictions from working for a competitor in a 50-mile radius may be reasonable depending on the industry.
Suppose that the contract Jane signed has a five year non-compete clause. Jane decides to quit Dog Houses and work for a competitor after six months of employment. What happens? First, unless and until Dog Houses sues Jane, there would be no enforcement of the contract, and Jane would go on with her employment at the competitor. However, Dog Houses could sue Jane for violating the terms of the non-compete agreement, which, as discussed, includes over-broad restrictions. In this case, the case may go to court.
Some courts (not Nebraska) apply what is called the ‘blue pencil’ rule, which essentially means that the court will reform the non-compete clause to make the contract enforceable against Jane, by perhaps rewriting the non-compete for one year rather than five. However, Nebraska courts do not apply this rule to reform non-compete contracts to make them compliant with the rules. Nebraska courts are not in the business of helping companies that chill employee behavior by giving those same employers maximum non-compete protection. While each case is handled on an individual basis and courts weigh public policy and law, if the non-compete clause is unenforceable, the contract is not reformed – instead, the court would likely declare the entire agreement void.
To sum up, courts will not enforce a clause so broad that employees are prevented from working anywhere else, but they will enforce a non-compete clause to the extent necessary to protect the employer’s interest in its information. The key is that the clause must have reasonable limitations both in time and in space.