How do Non-Compete Agreements Work


What is a Non-Compete Agreement

A non-compete agreement is a contract pursuant to which one party agrees not to engage in business activities that compete with the business of the other party. The agreement may be incorporated as a clause in a larger contract, such as an employment contract or the contract for the sale of a business. This type of agreement is also known as a covenant not to compete.

Non-compete agreements are often included within contracts for:

  • Employment – Non-compete agreements are common in an employment context, with an employee agreeing not to compete with a former employer for an agreed period of time after the end of the employment relationship.
  • Sale of a Business – Non-compete clauses are routinely included in contracts for the sale of a business, with the seller agreeing not to compete with the buyer.
  • Business-to-Business Transactions – Non-compete agreements may be incorporated into contracts with business partners, vendors or independent contractors, who may otherwise be able to take advantage of information that they learn while working with a business in order to later compete with the business that employs their services.

What Terms are Included in a Non-Compete Agreement

A non-compete agreement describes restrictions on what competition is permitted, where it is permitted, and the length of time that any restrictions on competition remain in effect. The terms of a non-compete agreement will thus normally focus on three issues:

  • Scope – What sort of business venture is restricted or forbidden during the term of the agreement?
  • Time – For how long after the end of a business or employment relationship will the non-compete agreement remain in effect?
  • Distance – Over what distance or geographic range is the non-compete agreement in effect?

Are Non-Compete Agreements Legal

Most U.S. jurisdictions allow non-compete agreements in an employment context, or in a business-to-business contract, and all allow non-competes in contracts for the sale of a business. Thus, in most jurisdictions an employee can be required to sign a non-compete agreement by an employer or prospective employer.

Some jurisdictions disfavor non-competes in the context of employment. For example, California, Montana, North Dakota, and Oklahoma prohibit non-compete agreements for employees, and Illinois prohibits them for low-level employees. In California, outside of the context of the sale of a business, non-compete agreements are not normally enforceable.

Even in states that will not enforce non-compete agreements, it may be possible for a past, out-of-state employer or party to a contract to enforce a non-compete agreement in that other state's courts.  If a non-compete is valid under the laws of the state in which it was executed, and in which the business transaction or employment occurred, then litigation to enforce the contract remains possible in that state.

Similar Contractual Covenants

In addition to a non-compete provision, a contract for employment, services or the sale of a business may include additional covenants to protect the business from competition. Two common examples are:

  • Non-disclosure agreements – An agreement that certain information is considered to be the property of the business, and that the restrained person will not utilize or share that information in any other context.
  • Non-solicitation agreements – An agreement that during the term of the contract, and possibly for a period of time after its conclusion, that the restricted party will not solicit customers or employees of the business.

Non-disclosure and non-solicitation agreements are more broadly enforceable than non-competition agreements, and are evaluated under different legal standards.

When Are Non-Compete Agreements Enforceable

To be enforceable, a non-compete agreement must be adequately supported by consideration at the time it is signed, it must protect a legitimate business interest, and must be reasonable in its scope, duration, and geographic limits.

Consideration

In order for the clause to be enforceable, something of value must be received by the person agreeing to a non-compete clause. In the sale of a business, the terms of the sale and payment for the business are sufficient. In an employment context, if the agreement is entered as a condition of being hired, the creating of the employment relationship is normally sufficient.

If an employer asks an existing employee to sign a non-compete agreement, it will generally be necessary to offer more than continued employment to render the agreement enforceable, such as a raise or promotion.

Legitimate business interests

The states that allow non-compete agreements do so out of recognition that businesses may be at a disadvantage if a business seller or certain former employees are able to compete with them without restriction. Nonetheless, any restriction must be related to the business's legitimate business interests.

For example, a non-compete clause cannot be used as a mechanism to hamper an employee's ability to get work with non-competing businesses.

Reasonableness

In most jurisdictions that allow non-compete agreements, courts will examine the reasonableness of the agreement's terms, to determine if its scope, duration, and geographic limitations are reasonable.

A non-compete agreement is more likely to be held valid in the context of the sale of a business, or in a business-to-business context, than in an employment context. Business owners and managers are assumed to be sophisticated in their understanding of contract terms. For the sale of a business, concerns about the seller potentially opening up a nearby competing enterprise that will draw away customers are significant.

For employment agreements, the reasonableness of a non-compete agreement will depend upon the nature of the employment. Also, employers are generally not permitted to enforce non-compete agreements that extend to geographic areas in which they do not conduct business.

For example, a geographic limitation on competing within a ten mile radius may be deemed unreasonable for a hairdresser, but a non-compete agreement for a business executive might be deemed reasonable despite a statewide or even nationwide restriction. Similarly, for a hairdresser, a court might be skeptical of a non-compete that was more than one year in duration, but might find reasonable a two- or three-year restriction on competition by a doctor or lawyer who left a local practice.

It is unlikely that a court would find enforceable a provision that prohibited a hairdresser from working in a beauty supply store, but it might enforce a prohibition on a person who sells a restaurant from operating as a caterer within the same general market.

How to Fight a Non-Compete Agreement

Before you create a battle strategy, sometimes the best approach to a non-competition agreement is to discuss your plan with your employer and to find out if your employer will agree that your plan is not a violation of the agreement, agree to a modified plan that it agrees will not be in violation, or agrees to waive the non-competition agreement such that you are free to carry out your plan without restriction.

If you are seeking employment that may violate a non-compete agreement:

  1. Make sure that your new employer is aware of the non-compete agreement.
  2. Have the actual language of the contract reviewed by a lawyer.
  3. Try to negotiate or settle any claims by your former employer.

Your lawyer may be able to assist with negotiation or settlement, or even be able to convince the other party that the agreement is not enforceable or does not apply to your new situation.

How are Non-Compete Agreements Enforced

A non-compete is enforced through litigation, a lawsuit filed in court. If you are unable to resolve your differences with the other party to a non-compete, your options include,

  • Declaratory Action – If you are restricted by a non-competition agreement, you may file a lawsuit asking that a court review the contract and the facts, and find that the noncompete is not enforceable.
  • Litigation – If you are seeking to enforce a non-competition agreement, you may file a lawsuit alleging that the other party has violated the agreement.
  • Wait and See – If you are restricted by an agreement, and you are willing to accept the risk, you can proceed with your new work and see if the other party takes legal action.

An party seeking to enforce a non-compete agreement may seek an injunction, asking a court to prohibit the other party from engaging in business or taking employment that it alleges to be in violation of the non-compete agreement. An employer will sometimes include a former employee's new employer in the lawsuit, alleging that the new employer encouraged the former employee to violate the terms of the agreement.

As litigation is expensive, some employers are will hesitate to sue to enforce a non-compete agreement. At the same time, some employers are much more willing to litigate to enforce non-compete clauses, and for many employees the cost of defending against the lawsuit can be oppressive.

Court Findings

If a court finds that the non-compete agreement is not adequately supported by consideration, or that it does not serve the legitimate business needs of the party seeking to enforce the agreement, the court will find that the agreement is not enforceable.

If the court finds that the contract is otherwise valid, the court will next examine the reasonableness of its scope, duration, and geography. If the court finds that the agreement is reasonable, the court will enforce the its restrictions.

If the court finds that the scope, duration, or geographic terms of the agreement are not reasonable, it may find that the agreement is unenforceable. But it is also possible that the court will instead limit or reduce terms of the agreement so as to render it reasonable, such as by allowing the agreement to be enforced but for a shorter period of time or in a smaller geographic area.

Differences in Contract Terms and State Law

Due to the variation in the language of non-compete clauses, and also in state law, any business owner or buyer who wants to impose enforceable non-compete terms should have the language drafted or reviewed by a lawyer in the state or states in which they conduct business. Similarly, an employee who is thinking about signing a non-compete agreement, or who wants to know how a court will interpret and apply the agreement, should have the actual language of the agreement reviewed by a lawyer in the state where enforcement would be sought.

Copyright © 2017 Aaron Larson, All rights reserved. No portion of this article may be reproduced without the express written permission of the copyright holder. If you use a quotation, excerpt or paraphrase of this article, except as otherwise authorized in writing by the author of the article you must cite this article as a source for your work and include a link back to the original article from any online materials that incorporate or are derived from the content of this article.

This article was last reviewed or amended on Jun 11, 2017.