The Critical Role of Non-Compete Contracts in Today’s Ever-Changing Environment
In June of 2023, New York passed non-compete legislation banning almost all non-competes in the state. New York joins many other states that already have a full or partial ban on non-competes.
“Only free men can negotiate. A prisoner cannot enter into contracts.”
— Nelson Mandela
There I was in an important board meeting with one of the nation’s largest exploration and production companies. We had just granted money and stock to key executives to sign non-competes that my team and I, along with a very prestigious law firm, had been working on for quite some time.
The energy industry had suffered a significant investment rotation away from it to other industries because the price of oil had dropped precipitously. Prior grants of their stock and long-term incentives were down, and they no longer retained the talent needed. Our plan to solve this was now in place. All seemed well, or so I thought.
* * *
Now with today’s fiercer and more competitive job market, attracting and retaining skilled executives and key employees is paramount to the success of each and every business. Non-compete agreements can serve as a vital tool to have valuable talent by protecting the company from competitive raids and fostering a sense of commitment – by employer and employee – to focus on common goals together.
Of note, I myself have always been under non-competes at KMPG Peat Marwick, Deloitte & Touche, and even at my own company, Longnecker & Associates, and I have always honored them.
* * *
The board meeting was just around the corner for our client. We were working through a pre-meeting with their Human Resources and Legal teams. As we went through the agenda, the executives in the room informed my team and me that they did not believe non-competes to be enforceable. My team and I were taken aback, so I asked, “So you sold the Board they WERE enforceable, you received compensation for this, and you have signed… but you sold the Board on something you did not believe in? To get money? And then not honor?”
Their unanimous reply was “YES!”. I shared my complete disagreement and knew then that we would have an interesting Board meeting, to say the least.
* * *
There are so many reasons why non-competes can play a major role in a business. I’ve already shared about retention, but some other significant reasons include:
1. Promote an Environment Conducive to Innovation and Investment: By safeguarding a company’s intellectual property, investors are more likely to invest and fund research and development (R&D) efforts, knowing their money is protected from potential threats posed by competitors purposing to hire a company’s key executives and/or employees. These agreements can give companies a sense of security to share sensitive knowledge with employees and collaborators, knowing that their intellectual property will not be stolen. This can encourage companies to invest more confidently and frequently in developing cutting-edge technologies and creative solutions, as they have greater confidence that others will not quickly replicate their efforts or walk away with their know-how.
2. Prevent Unfair Competition: In their absence, individuals with an intricate knowledge of a company’s operations, client lists, and proprietary processes could establish competing businesses and/or collaborate with rivals, resulting in significant harm to their present employer. These agreements are intended to mitigate the risk of unfair competition, industrial espionage, preserve a level playing field in the market, and promote healthy and ethical competition. I have had this happen to me numerous times in my career. Here are just two examples.
a. The first time was at KPMG, I hired a solid senior manager who came from a top firm. He was older than I was and was paid more than me. I had great expectations. Several months passed, and he had not sold anything. I finally asked IT to check his KMPG-issued phone. I called some of the numbers and was shocked to find that he had set up his own consulting practice. He told clients that KMPG has two offerings, one through KMPG, but also a second option that was a cheaper, private firm – HIS! He had taken in well over $100,000 personally. Needless to say, he was let go.
b. Years later, when I was hoping I was smarter, I bought a boutique search firm thinking our synergies would be amazing. Again, months go by… nothing. Again, I have our IT/security group investigate. Sure enough, he had set up another search firm in another major metropolitan area. Goodness, I was upset, and he, too, was shown the door.
Thankfully, the non-competes they had – although not honored – were critical in our ability to safeguard our investment with these non-ethical individuals and our competitive advantage and reputation with our clients.
3. Protect Client Relationships:
“Strive not to be a success, but rather to be of value.”
— Albert Einstein
Einstein was right, and being a true protector and keeper of client relationships is key to creating and maintaining their value. For businesses that rely heavily on client relationships and customer loyalty – which is most – non-compete agreements serve as a valuable tool to retain their customer base. When key executives and/or employees leave, the risk of them poaching other employees or customers – or worse, disparaging you to clients – can increase. These issues diminish significantly when appropriate non-compete agreements are in place.
By implementing non-compete agreements, companies can ensure that departing employees are prohibited from engaging in activities that could irreparably harm the company’s business, such as attempting to steal clients, disparage the company, and/or provide services that directly compete. This protection is critical for companies to retain clients, maintain a solid reputation, and continue to provide services without immediate competition from former employees with inside knowledge and know-how.
* * *
There my team and I are sitting in the Board meeting with key executives, outside advisors, the CEO, and the Board. We immediately dove into the non-compete agreements. Management asked their external legal advisor to discuss this. He is with a great firm and incredibly good. He shares that, in his opinion, they are not enforceable. He rambles on a bit, and when he finishes, all eyes look at me – about 20 sets!
I smile, pray for wisdom, and then I get to it.
Me: So let me get this right – you designed and drafted these documents, assured they were enforceable, and got paid for such assurances?
Attorney: Yes.
Me: Interesting. So you and I are presently working with three other companies where we are putting these in. Do any of them know you believe it is a “fool’s errand” and you are getting paid for “air”?
Attorney: He was incensed. I just stared at him… point made / point taken.
Afterward, I was called by the Chief Legal Officer to share the fact that the CEO had put them all up to it, and their jobs were on the line. I just shared, “Then you must be working for the wrong CEO.”
The next day, I received several calls from the Board to say thank you! I appreciated those calls, but in the end, that is what I do – protect shareholders, stakeholders, and the business community from bad players. Years later, that company was sold.
4. Enhance Mergers & Acquisitions:
In the context of mergers and acquisitions and/or strategic transactions, non-compete agreements create value for the seller since they are crucial in ensuring a smooth and reputable business transaction. These agreements are critical in ensuring acquirers that what they buy is secure. Further, it is a covenant that key people from the acquired company will not join competitors or immediately start a competing company – for a certain period – thereby preserving the value of the acquisition and what was paid. Non-compete agreements also help maintain the continuity of business operations and safeguard sensitive information up until, in, and through the transaction – which keeps the acquisition on track to create value.
SUMMARY
Non-compete agreements can positively and negatively affect innovation, investment, and trust. On the one hand, when reasonably drafted and thereby enforceable, they can protect a company’s confidential information and prevent key employees from leaving and joining/creating competition. On the other hand, overly restrictive and thereby non-enforceable non-compete agreements may stifle what a company hopes for by limiting employees to using all their talents.
Bottom-line:
- I like non-compete agreements.
- I do not like advisors who put them in that are not willing to “backstop” their work.
- It is critical to find an ethical, purpose-driven advisor.
- My recommendation – someone like Leela Madan of Madan Law PLLC (www.madan-law.com).
Attack, research, and consider – it could provide all the difference you need in keeping your and your company’s reputation solid and intact.