How Non-competes Affect Entrepreneurs in the USA

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2000px-Simple_supply_and_demand.svgMany would-be entrepreneurs are being kept back by the non-competes they signed with their employers or former employers. However, often, non-competes are not actually binding agreements. In particular, if a employer or former employer does not make special payments to the employee, then the agreement is likely void. For instance, many employees sign non-competes when they are hired on. These agreements are rarely valid unless they prescribe ongoing payments to the employee upon termination of employment. Usually, half of the employee’s salary should be paid on an ongoing basis (or in lump sum post employment) for a non-compete to be valid. Note, non-competes during employment are more likely to be valid, especially for executives.

Other restrictions on non-competes should also be considered. Firstly, in addition to special payments, these agreements should be territoriality bound, and have a short time limit. The narrower the territorial boundary (e.g., one city) and the shorter the time period (e.g., 1 year), the more like the agreement can be binding. So if an employer asks for global coverage for 10 years, this is almost certainly not going to hold up in court.

Another consideration if the extent of intellectual property in the form of trade secrets (technical knowhow, client exposure/lists, etc…) is involved. Many new firms are founded when account managers and delivery people poach clients away from their former employers. However, in many cases, it is difficult to distinguish between market and technical data that makes up a normal part of an employees professional skill set versus what is owned by the employer. For instance, a client list in an employee’s mind may overlap with normal industry knowledge that is not particular to a one firm.

Employees also sometimes feel bound by loyalty to their employers, especially when they have signed non-competes. This type of loyalty can be limiting for potential entrepreneurs, and may not be best for the economy and for society. More competition is usually good for consumers, after all. Which is the higher moral road: loyalty to an employer over an invalid non-compete, or responsibility to society to boost the economy through new venture creation? Spinouts from incumbent firms have better knowledge, survive longer, and have higher performance than normal startups and incumbent initiatives.

Not surprisingly, start-ups benefit from weaker property rights. States such as California, that refuse to enforce non-compete agreements and tend to side with employees in trade secrets cases, spur more spinouts. States that do not enforce non-compete agreements have more startups shortly after exogenous shocks (e.g., steep incumbent market downturn due to new technology). For instance, research suggests that residents of Michigan (which weakened its laws regarding non-compete agreements in 1984), there were more entrepreneurial after non-compete enforcement was relaxed.