Are Non-Competes a Good Idea? Depends On Whom You Talk To

In the most recent season finale of HBO’s Silicon Valley, the lead character, Richard Hendricks, appeared to be on the verge of losing the rights to his company’s intellectual property in arbitration to a previous employer, a thinly-disguised caricature of Google called Hooli. Hendricks’s employment contract clearly gave Hooli the rights to the IP.

To the surprise of everyone, the arbitrator ruled that, since Hooli’s employment contract contained a non-competition clause, the entire agreement, including the provision giving Hooli the rights to Hendricks’s IP, was invalid under California law. The result: Hendricks and his startup, Pied Piper, survived. At least until next season.

The arbitrator may not have gotten the law exactly right. Section 16600 of California’s Business and Professions Code provides that “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” So the whole contract probably wasn’t void. But you get the larger point. Non-competition clauses, with the limited exceptions, are illegal in California.

Ironically, the provision of California’s statutes that invalidates non-competition agreements was originally proposed in New York in 1865. Although New York never adopted the ban, California thought it was a good idea and passed essentially the same law in 1872. Today, California is one of just three states that place statutory limitations on non-compete agreements (although others are considering the issue), and the one that has by far the broadest prohibition.

A non-competition agreement, also known as a covenant not to compete, and a non-compete for short, is a promise by an employee not to compete with his or her employer for a specified time after the employment relationship is terminated, in most cases in a specified area. The agreement not to complete is usually a provision in the employment agreement.

In most states, courts use a reasonableness test to analyze the rights of the departing employee who signed the covenant not to compete with the former employer. The test involves consideration of the geographic area involved, the length of time of the restriction and the interests the contract intends to protect. Most courts won’t reinforce a bar preventing someone from earning a living altogether. Judges often have the power to rewrite contracts to conform with their idea of what is reasonable. For example, if a judge believes that three years is too long a restriction, it can be reduced to 18 months, or some other term.

Non-competes in the financial and technology industries pose special challenges. Traditionally, non-competes contained geographical limitations. Therefore, the owners of a medical practice typically require their physician employees to promise not to see patients within a geographical area–say, within a radius of 10 or 15 miles from the office in which they worked. The requirement is one born of fear that the employees would quickly decamp and take along with them patients with whom they had developed a relationship.

While patients don’t normally travel more than 10 or 15 miles to see a doctor, the consumers of technology and financial services often are not limited by geography. They may be in different states or even different countries from the companies with which they deal. So non-competes in these industries are typically limited by time, but not space. Courts seem to have gone along with these bans.

The policy arguments for and against non-competes are familiar. Detractors say they are used to control and intimidate and limit employee opportunities in the market, which already favors employers. The more modern objection, applicable for higher wage employees, is that post-employment restrictions have a chilling effect on innovation and limit career flexibility and incentives.

Defenders say that non-competition agreements are necessary because a firm may lose money and clients, which they have probably made a significant investment in developing, when the employee leaves. In other words, employers see this as protection against what they view as unfair competition. A post-employment restriction, they also contend, is necessary to protect intellectual property, trade secrets and confidential information. It is after all impossible to un-learn something picked up from an employer’s investment.

Although most of these claims are difficult to assess, there is some evidence to bolster one of the arguments of the opponents. Research has shown that information flows more freely (in California) where there are no non-competes. But this comes at a cost–namely, the inflated salaries needed to convince talented employees to stay put.

So where should you come down on this? It really depends where you begin.

As lawyers, we do not have an interest in the outcome. In 1961, the American Bar Association adopted a disciplinary rule governing the practice of law, which essentially banned non-competes because they limited a lawyer’s professional freedom and placed restrictions on the client’s right to choose any attorney. The rule effectively separated lawyers from professionals whose post-employment restrictions are judged by a test of reasonableness or, in some cases, a state statute defining the parameters of the non-compete.

Here’s what we can say: A ban on non-competes would probably make the somewhat chaotic employment markets, especially in the financial and technology industries, at least for talented employees, even more fluid. The policy considerations here depend upon whether one places a greater value on a freely moving workforce, maximizing the return on ideas, or the return on capital that might represent stranded investment without some legal protection. You can be the judge of whether or not that is a good thing.