Non-Compete Agreements: Understanding The Purpose And Legality

Early this year, the Federal Trade Commission proposed a new rule to ban employers from imposing noncompetes on their workers. It came after President Joe Biden's executive order in July 2021 urging the FTC to limit the use of non-compete clauses and other restrictive covenants. Many believe that non-compete agreements are employer overreach and restrict employees from seeking better opportunities and entrepreneurs from starting new businesses. The debate is ongoing, and the FTC’s proposed rule is yet to become law. But before you pick a side in the argument, here’s all you need to know about non-compete agreements, their purpose, scope, and legality.

What is a non-compete agreement?

A non-compete agreement, also known as a non-competition agreement or a covenant not to compete (CNC), is a legally binding contract between an employer and an employee (or between businesses) in which one party agrees not to engage in certain competitive activities that may be detrimental to the other party's interests. The purpose of a non-compete agreement is to restrict individuals or entities from working for or starting a competing business, typically within a specified geographic area and for a specific duration after the termination of employment or business relationship. 

Non-compete agreements are popular in various industries, especially where employees have access to sensitive information & trade secrets or have close relationships with clients or customers. Employers use non-compete agreements to protect their intellectual property, confidential information, customer base, and competitive advantage from being exploited by former employees or competitors.

What are the components of a non-compete agreement?

Non-compete agreements come into play at the onset of a professional relationship between an employer and an employee. It can be a legal contract in its own right or just a clause in a much larger employment agreement. Depending on the industry and the nature of employment, non-competes may vary from person to person. But a non-compete agreement typically includes the following elements:

Scope of Restriction: The non-compete contract must clearly define the scope of the restriction. It must specify the activities or services, unique to the business or otherwise proprietary, that the Employee or Contractor is prohibited from engaging in during the restricted period. 

Restricted Period: Non-compete agreements usually specify the duration of the restriction. Depending on the jurisdiction and industry, it is typically limited to a reasonable time frame, ranging from several months to a few years. As long-term restrictions can hinder an employee’s ability to find work after termination or resignation.

Geographic Area: The non-compete agreement must mention the geographic area within which the Employee or Contractor cannot compete. This area should be reasonable and directly related to the Company's business interests. For instance, the geographic limitation may range from a particular area surrounding the company's headquarters to specific towns where the business conducts business.

Competitors: Non-compete agreements should identify the competitors or types of businesses the restricted party cannot engage with. This specification ensures that the scope of the non-compete agreement is reasonable and not overly restrictive. Vague or broad descriptions of competitors may render the agreement unenforceable.

Damages: When drafting a non-compete agreement, it is crucial to include clear and specific language regarding the consequences of a breach to ensure enforceability and clarity. It may be a liquidated damages clause, where both parties agree on a predetermined amount of damages or injunctive relief. The damages must be proportionate to the harm caused by the breach.

What is the purpose of a non-compete agreement?

A non-compete agreement's primary goal is to prevent a person or employee from participating in certain competitive activities that could harm the employers. Businesses across job levels, from doctors and tv executives to advertisers and warehouse workers, insist on noncompete clauses or agreements to maintain their competitive edge. Non-compete agreements serve various purposes, and their enforcement can vary depending on local laws and jurisdictions. Their primary goals are as follows:

Protection of Intellectual Property and Trade Secrets: Non-compete agreements safeguard a company's intellectual property, trade secrets, proprietary information, and confidential data. They prevent former employees from using such knowledge to benefit competitors or start competing ventures.

Preserving Customer Relationships: In industries where client relationships are crucial, non-compete agreements prevent departing employees from poaching or soliciting the company's customers, thus protecting the business's customer base.

Maintaining Market Share: Non-compete agreements can help companies sustain their market share by preventing former employees from establishing rival businesses that may directly compete with their products or services.

Encouraging Investment in Employee Training: Some industries invest heavily in training employees or providing specialized knowledge. Non-compete agreements can incentivize companies to invest in their workforce without the risk of losing trained employees to competitors.

Encouraging Innovation and Research: In certain industries like technology and pharmaceuticals, non-compete agreements help protect ongoing research and development efforts, preventing former employees from taking proprietary knowledge to rival companies.

While they protect intellectual property and sensitive information, non-compete agreements aren’t the same as non-disclosure contracts. Non-Disclosure Agreements, also known as confidentiality agreements, are contracts designed to protect confidential and proprietary information shared between parties. NDAs prevent the recipient from disclosing or sharing the information with third parties without authorization.

Who Uses Non-Compete Agreements?

Employers or companies usually prefer non-compete agreements to protect their business interests. They are typically included as a clause in employment contracts, partnership agreements, or as separate standalone agreements when hiring key personnel, executives, or employees with access to sensitive information. They are prevalent in various industries, particularly those where protecting intellectual property and customer relationships is crucial. 

Technology and Software: Companies in the technology sector often use non-compete agreements to protect their proprietary software, algorithms, and technological innovations.

Pharmaceuticals and Biotechnology: Non-compete agreements are common in pharmaceutical companies to safeguard ongoing research, development, and intellectual property related to drugs and medical advancements.

Healthcare: Healthcare organizations may use non-compete agreements to prevent doctors, specialists, or key medical staff from leaving and establishing competing practices in the same geographic region.

Manufacturing and Engineering: Companies in manufacturing and engineering industries use non-compete agreements to protect trade secrets and proprietary manufacturing processes.

Finance and Investment: Financial firms, such as investment banks and hedge funds, may employ non-compete agreements to prevent employees from joining rival firms and taking clients or proprietary investment strategies.

What is the legal status of non-compete agreements in the US?

The enforceability of non-compete agreements varies by jurisdiction, as some regions may have specific laws that restrict or regulate their use. Non-compete laws are primarily governed by state laws rather than federal laws in the United States. Each state has its statutes and regulations regarding the enforceability of non-compete agreements. Some states have stricter laws that limit the enforceability of these agreements, while others may be more lenient. For instance, while California does not legally recognize non-compete agreements, Utah does with certain limitations.

To be enforceable, non-compete agreements must be reasonable in terms of scope, duration, and geographic area. Courts may consider whether the restrictions are necessary to protect the employer's legitimate interests without imposing undue hardship on the employee. According to the FTC's most recent position, non-compete agreements prevent employees from freely switching jobs or advancing in their careers. The FTC aims to foster greater fluidity, innovation, and healthy competition by prohibiting this behavior. 

Conclusion

The use of non-compete agreements has both benefits and drawbacks. On one hand, non-compete agreements can safeguard a company's intellectual property, maintain its market position, and prevent the loss of valuable talent and business relationships. They can also incentivize investment in employee training and foster innovation within the organization.

On the other hand, non-compete agreements have faced criticism due to their potential to hinder employee mobility, limit job opportunities, and stifle entrepreneurship. Critics argue that overly restrictive non-compete agreements may impede economic growth and create barriers for workers seeking new opportunities.

Dock 365 contract management software is ideal for businesses that rely on non-compete agreements. These software solutions streamline the contract creation process, provide templates, and offer tools to track and store non-compete agreements efficiently.