Think All Noncompetes Stink?

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.