What Is a Non-Compete Agreement?
A non-compete agreement is a legal document that restricts one party from competing with another in the same industry or geographical area. For example, consider a software development company that hires John as a senior developer. During his employment, John gains access to proprietary software code and client lists that give the business a competitive edge in the industry.
The author of a non-compete agreement must draft it according to state laws and ensure it contains reasonable provisions.
Requirements for a Non-Compete Agreement
Here are the requirements for a non-compete agreement:
- Legitimate interest: A business can’t implement a non-compete agreement just to minimize competition. Instead, it must prevent a legitimate threat to the company’s operations.
- Scope of work: A business should define the activities an employer is prohibited from performing.
- Consideration: A business must make the benefits of a non-compete agreement clear for both parties.
- Duration: A business must implement a definitive and reasonable term for the non-compete agreement.
- Geographical area: A business must clearly define the geographical area in which the other party can’t compete.
When to Use a Non-Compete Agreement
This agreement goes into effect once the employee or contractor severs ties with the company. There are a few ways that a company can draw up non-compete agreements and a few scenarios in which they would be helpful:
- Protecting confidentiality
- Hiring employees or contractors
- Dissolving a partnership
- Selling a business
For example, David, the owner of a successful coffee shop chain, decides to sell his business to a larger competitor, BrewMasters Inc. As part of the sale, David agrees to a non-compete clause that prohibits him from opening a new coffee shop within a 100-mile radius for three years.
This clause protects BrewMasters from immediate competition by ensuring that David, with his industry experience and customer base, does not start a new venture that could draw away customers from the business he just sold.
Why You Need a Non-Compete Agreement
Employees are valuable components of your company. Depending on the level and specialization of the employee, they often know your business and industry intricately. This knowledge helps them make your company successful. But given to a competing entity, it could be a distinct disadvantage to your organization.
Without a non-compete agreement, a key employee could leave and would likely stay in the area and the same industry. While companies can’t stop employees from moving on or working in the field, they also shouldn’t risk intellectual property or insider knowledge being used against them.
Here are some possible outcomes without this agreement in place:
- Employees could leverage their knowledge of your company to secure a high-ranking position with your direct competition: As shady as this sounds, it happens. Employees can and should look out for their own best interests. That would include looking for the highest-paid position in their industry. A solid business practice pays employees fairly for their contribution and ensures staff is satisfied with the company. This agreement would ensure that high-ranking employees couldn’t use knowledge of your company to secure employment with direct competitors.
- An employee could use the knowledge gained through your company to open their competing enterprise: Many employees may want to be their boss. While there’s nothing wrong with employees having long-term goals for their industry growth, your company can’t afford to teach people the industry to have them turn around and use that knowledge to compete directly with your interests. Without a non-compete agreement, employees could open their firm in the same area, using connections and knowledge they gained while working for your firm.
- An employee could leave and hire away key employees: Without this contract, an employee who takes a position in another company or forms their own company might also court employees from your company to leave with them. Remember, these are colleagues they have developed a relationship with, and the outcome could be disastrous to your firm.
How to Create a Non-Compete Agreement
Here’s a list of steps you can follow to create a non-compete agreement:
Step 1 – Research the Laws in Your State
Check your state’s laws, but keep in mind that the FTC’s Final Rule now sets federal standards that may supersede state laws. Ensure your agreement complies with both state regulations and the new federal rules.
Step 2 – Determine Permissible Use
Since most non-compete agreements are now prohibited, confirm whether your agreement is applicable. It may still be valid for senior executives or in the context of the sale of a business.
Step 3 – Define Scope and Duration
If creating a permissible non-compete, clearly define the scope of restricted activities and establish a reasonable duration. Be aware that the FTC’s Final Rule limits the use of non-competes, particularly regarding duration and scope.
Step 4 – Consider Alternatives
Given the restrictions on non-competes, you might want to focus on drafting non-disclosure and non-solicitation agreements to protect your business interests. These can be effective substitutes in most cases where non-competes are no longer allowed.
Step 5 – Acquire Signatures
Once your agreement is drafted and complies with applicable laws, ensure it is signed by all relevant parties. This includes obtaining signatures from the parties to be bound by the agreement.
