Non-Compete agreements can hedge risk amidst an acquisition, but are they always enforceable?

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What are Non-Compete Agreements?

A non-compete agreement, also known as a covenant not to compete (CNC), is a legal contract between an employer and an employee, or between businesses, where one party agrees not to enter into, start, or engage in a similar profession, trade, or business that competes with the other party. The purpose of such agreements is typically to protect the legitimate business interests, e.g. trade secrets, client relationships, and confidential information of the employer or buyer.

Non-Compete Agreement of Business Seller

A non-compete agreement with a seller of a business is a contractual arrangement that restricts the seller from engaging in certain competitive activities after the sale of their business. This type of agreement is commonly included as part of the overall business sale transaction to protect the buyer's interests. The intent is to ensure that the seller, who has intimate knowledge of the business operations, doesn't immediately start a competing business or work for a competitor, potentially undermining the value of the acquired business

Non-Compete Employment Agreement of Key Employees

Alternatively, a non-compete agreement with a key employee is a legal contract between an employer and a key employee that restricts the employee from engaging in competitive activities if they happen to leave the company, especially immediately after an acquisition. The purpose is to protect the buyer’s business interests, such as customer relationships, and prevent the key employee from working for a competitor or even starting a competing business, for a specified period and within a defined geographic area at least.

From Real Life:

An entrepreneur purchased a local manufacturing and installation business chiefly due to the lack of competition in a broad geographic region. Upon acquisition, the seller communicated that his key employee had committed to stay on with the new owner. Yet after two weeks of new ownership, the key employee resigned, citing his ability to run the business better on his own. Over the next year, the owner of the newly acquired business lost more than one competitive contract to this key employee’s newly formed sole proprietorship.

It turns out there was more to the story, however. A surprise call came to the entrepreneur of the newly acquired business a few months after losing his first bid to the former key employee. It was the client who had awarded the sizable contract to the former key employee. The client explained that the key Employee had not only failed to begin work as contracted but was also completely unresponsive to the client’s emails. The client had called the entrepreneur of the newly acquired business to ask him to complete the contract instead.

The entrepreneur accepted the contract but would neither match the unrealistically low bid of the former key employee nor commit to the now near-eminent original completion date. However, a new contract was drawn up between the entrepreneur and the client with reasonable terms.

The entrepreneur received a very similar call from another client a month later. Even though the entrepreneur of the newly acquired company was still able to complete these contracts, the rogue key employee proved a disruptor to his market. A non-compete agreement with the key employee, drawn up according to the vital elements listed below, may have prevented these challenges, at least within a reasonable geographic region.

Vital Elements of a Non-Compete Agreement

The strength of the non-compete agreement will depend on the laws of the jurisdiction in which it is being enforced. Courts may scrutinize such agreements to ensure they are reasonable in scope, duration, and geographic restrictions.

Below are some vital elements of non-compete agreement:

Scope of Restrictions: Clearly define the specific activities or industries that the key employee or seller of the business is prohibited from engaging in during the non-compete period. This could include working for a direct competitor, starting a competing business, or soliciting the buyer’s clients.
Duration: Specify the length of time the non-compete restrictions will be in effect. The duration can vary, but it is typically one to two years, depending on the industry and the nature of the business.
Geographic Limitations: Define the geographic area where competition is restricted. The geographic scope could be local, regional, national, or even global, depending on the employer's business interests. A specific measurement, like a 50 miles radius can strengthen the agreement.
Key Employee: If the agreement is between employer and employee, it should be restricted to a key employee of the business. Courts have been less assertive enforcing non-compete clauses with employees of a less pivotal or crucial nature to the business.

Are They Enforceable?

While non-compete agreements can be enforceable, their enforceability is subject to legal scrutiny and may vary depending on jurisdiction-specific laws and circumstances surrounding the agreement.

States that are known for having stricter standards or limitations on the enforceability of non-compete agreements include:

California: California has a strong public policy against non-compete agreements and generally considers them void except in very limited circumstances.
North Dakota: Non-compete agreements are disfavored in North Dakota, and courts may scrutinize them closely.
Oklahoma: Oklahoma has specific statutory restrictions on the enforceability of non-compete agreements, and they are generally disallowed for certain professions.
Montana: Montana law places restrictions on non-compete agreements, and they are subject to scrutiny to ensure reasonableness.

Other states, contrastingly, allow non-competes, as long as they provide specific terms in the aforementioned four vital elements.

Case Law on Non-Competes

To illustrate what some courts have allowed or disallowed in non-competes, below is an excerpt from a law office specializing in business law:

In Brand Makers Promotional Products, LLC v. Archibald, plaintiff Brand Makers asserted several claims, including breach of contract, against defendant Nathan Archibald, a prior employee and co-founder of the company. The breach of contract claim was based on allegations that Archibald breached a non-solicitation and confidentiality agreement by competing with the company and soliciting its customers.

The Brand Makers court held the agreement was unreasonable, and therefore unenforceable, because the contract imposed a greater than necessary restraint on Archibald in the company’s attempt to protect its business interests. Specifically, the court noted the contract was silent with regard to the limitation of scope of employment or line of business, and silent with regard to geographical limitations, which in turn “impose[d] a greater restraint than is reasonably necessary to protect the employer's legitimate business interests.”

Notably, the Archibald court declined to modify, or blue-pencil, the agreement, despite acknowledging its ability to do so, stating: Section 44-2703 “does not require the court to insert terms into a non-compete agreement in order to render it reasonable when such terms are absent on the face of the provision,” possibly narrowing the scope of Idaho’s blue-penciling statute, or at least, indicating the court’s apprehension to insert terms into an otherwise valid contract.

It would serve you well to review your non-compete agreements and make sure they fall within the presumptions set forth by the APLBI – i.e., duration, geographical area, type of employment, and key employees. This is critical because having your non-compete agreements fall within these presumptions will place the burden on your prior employee to show that their non-compete agreement is unreasonable. Further, you cannot rely upon courts to completely rewrite your non-compete agreements using the “blue pencil rule.”

Wrap Up

In summary, it’s essential for both parties to carefully negotiate and draft the terms of the non-compete agreement. Striking a balance between protecting the buyer's interests and ensuring that the seller's or key employee’s ability to earn a living is not unreasonably restricted can be challenging. To ensure a greater chance of enforcement, legal advice in drafting such agreements is often sought during acquisition negotiations.