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Under Contract

A noncompete agreement can protect your business. But will it hold up in court?

Suppose you have a key employee who knows your business inside and out: your trade secrets, your marketing strategies, your customers and your plans. Then suppose that employee gets a better job offer from your biggest competitor. Can you prevent the employee from working for the competitor and using his knowledge against you?

That depends on two factors: whether you had the employee sign a noncompete agreement and whether that agreement is enforceable in court.

In hopes of protecting valuable secrets, companies often ask key employees to sign noncompete agreements. Often part of a larger employment agreement, these contracts typically state that the employee will return confidential information before leaving the employer, will not reveal trade secrets, will not work for a direct competitor within a year or two after leaving, and will not solicit existing customers.

When employees violate the agreement by starting competing businesses or working for competitors, though, you may not be able to stop them. The problem is the tension between two important principles of American law: the right of business owners to protect their assets and the right of all businesses to free and open competition.

When noncompete agreements land in court, as they often do, courts must balance these two rights. In general, U.S. courts dislike these agreements because they restrain free trade, a pillar of our free enterprise system. They can also make it impossible for former employees to earn a living in their field. Accordingly, courts scrutinize noncompete agreements very closely and often refuse to enforce them.

Consider two cases involving small businesses, each of which went to the state Supreme Court. One, decided this year, concerned a small Nevada business that supplied commercial lighting equipment and replaced outmoded lighting systems. When the owner, Mark Deeter, hired an assistant, Larry Jones, he drafted a noncompete agreement and asked Jones to sign it in exchange for an extra 50 cents per hour. The agreement said Jones would not compete with Deeter in the lighting retrofitting business for five years within a 100-mile radius of Reno. If he did, he would pay Deeter $50,000 in damages.

Three months later, Jones was fired. He immediately contacted Sacramento Lighting Services, a major competitor, and became an independent sales representative. Deeter sued. The trial court found the agreement enforceable but reduced the damages to $3,500.

The Supreme Court of Nevada, though, ruled the covenant was simply too broad. The judges acknowledged that building a customer base in this field was difficult but ruled that the potential harm to Deeter didn't outweigh the unfairness to Jones: For five years, he wouldn't be able to work in his field without moving at least 100 miles from home. Since the covenant was unenforceable, the court also threw out the $3,500 award.

The second case concerns PWT, a Seattle accounting firm that hired an accountant to head its retirement planning department. The accountant signed a noncompete agreement promising not to provide services to any of the firm's clients within five years of leaving the firm. If she did, she would pay 50 percent of any fees collected to PWT.

For a year, she and two other employees in the department worked with numerous clients and intermediaries. Then all three quit and started their own firm, also in Seattle, specializing in retirement plan accounting. While none of their brochures went directly to PWT's clients, some went to intermediaries who referred former clients to the new firm. In 17 months, she'd performed $78,000 worth of services for former PWT clients.

The former employer sued; the trial court dismissed the case. Since the accountant didn't directly solicit her former employer's clients and didn't obtain any active clients, the court reasoned, PWT wasn't harmed. Therefore, the restriction and fee were unreasonable.

But the Supreme Court of Washington disagreed. The court noted the accountant stayed only long enough to ingratiate herself with the firm's clients, left with the entire department and ended up with several of those clients. The court ruled the covenant was "proper, reasonable and enforceable" since the former employer had a legitimate interest in protecting its client base and hadn't asked her not to practice accounting in the area at all. Likewise, the court ruled that, given accounting industry practices, the 50 percent fee was a fair price for acquiring a client.

In such cases, courts look at whether the employer has a legitimate interest in protecting its secrets or client base. First, if the business didn't really have any trade secrets or if the employee didn't have access to them, a court is less likely to enforce a noncompete agreement.

Second, courts look at whether the restrictions placed on the employee were reasonable and fair. If not, courts feel free to declare the agreement unenforceable or revise it. State courts and legislatures vary as to what "fair and reasonable" means, but most insist the agreement be limited with respect to time, place and scope. Normally, the prohibition on competition must not extend more than two years after employment ends. The territory restricted should be limited to the market area encompassing the majority of the employer's customers. For example, it's unreasonable to prohibit a real estate agent from competing in the entire state. The agreement should also be limited in scope--not forbidding the manager of a fast-food restaurant, for example, from managing the restaurant at a country club. And courts seem more willing
to enforce agreements that allow former employees to operate a competing business as long as it doesn't solicit current customers.

Third, courts examine whether the employee received any "consideration" for signing the agreement. Under contract law, both sides must receive something. If the employee must sign the agreement to obtain the job, landing the job is adequate consideration. If you ask for a signature later, it should be tied to a promotion or raise. Tell the employee that, with this new level of responsibility, you expect a new level of confidentiality. Some companies wait until key employees are leaving, then pay them to sign the agreement--possibly renewable year by year for an additional fee.

If you hire someone who signed an agreement not to compete with a former employer, you could face a lawsuit as well. Before hiring, call the former employer, say you don't want to violate anyone's rights, and find out what the employee may and may not do. Whichever side you're on, the key is being reasonable and fair.

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This article was originally published in the October 1996 print edition of Entrepreneur with the headline: Under Contract.

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