For many startups, founders are the most important assets of a company. After all, these are the individuals who are going to innovate and grow the company into a profitable business. What happens when the relationship between founders sours and someone wants to leave the company? How can entrepreneurs protect their startups from the fallout of such a rift? One answer is through a non-compete agreement. This post will give an overview of the non-compete agreement, its legality, and important items to discuss within a non-compete agreement.
New York is an at-will employment state. This means that in almost all employment matters, there is a presumption that either party can terminate the employer-employee relationship “at will.”[i] Unless an agreement between founders exists that restricts how a founder can be removed from his or her position, any party can terminate this relationship at any time. Even if an agreement is in place to protect founders from “firing” one another without cause, a founder still has the right to leave the company when he or she chooses to do so. Once a founder decides to leave a startup, he or she has the right to find employment in the field of his or her choosing, even if the new position could compete with the startup. Therefore, it is prudent for founders to obligate one another to a non-compete arrangement.[ii]
Non-compete agreements are self-explanatory. They are promises between contracting parties not to compete against each other. While the concept is simple, enforcing a non-compete agreement is not as straightforward. Non-compete agreements will only be enforced if they are reasonable and necessary under the circumstances.[iii] Drafting a non-compete that is enforceable is about finding the balance between protecting the interests of the business and the exiting party’s right to make a living.[iv] Because the nature of a non-compete agreement is to prohibit someone from working in a particular field, the contract’s scope, duration and distance is limited. Restrictions upon the agreement’s scope and duration are fluid; they depend on the nature of the founder’s contributions in the field.
Scope of Work
A non-compete can limit the scope of work in which a founder could work after leaving a startup. The language in the agreement cannot be so broad as to render the founder effectively unable to make a living in his or her field or specialty. It can, however, be worded so that the founder is less likely to be poached by competing companies or from starting his or her own business in the same field. For example, a non-compete agreement restricting an exiting founder from developing software with similar capabilities as the startup’s proprietary code may be enforceable. A non-compete agreement restricting a founder from developing any code at all, however, would not.
The geographic scope of the agreement pertains to the geographic reach of the non-compete clause: that is, the extent to which a founder is restricted to practice in a particular geographic area after leaving the company. This component of the non-compete agreement must also be limited if the agreement is to remain enforceable. Remember the concept behind enforceability is that the agreement itself must not place too much of a burden on the employee’s right to work.[v] An agreement completely restricting an exiting founder from working within the same state as the company from which he or she is leaving is likely too prohibitive to be enforceable. Restricting a founder from practicing within the same county as the startup may be appropriate. As with scope and duration, this notion is also fluid—it depends on the type of business. It is more likely that an agreement restricting founders of a small sales company from competing within a two-county radius is enforceable rather than an internet sales group that restricts its founders from joining another internet sales firm.
The duration of a non-compete pertains to the amount of time one is obligated to the terms of the agreement. No non-compete agreement can be indefinite. Instead, the duration must reflect the nature of the business in which the non-compete applies. Software companies, for example, are constantly creating new work. Software products are never stagnate, they are updated frequently. It is unlikely then that a non-compete limiting a founder of a software company from working on a type of software product for five years is enforceable because the company’s software product may be obsolete after only a year. A non-compete agreement obligating founders of a sales company not to compete for a period of three years may be enforceable because client relationships are the crux of the business and those relationships often take years of development in order to secure.
Generally, a two-year term is an acceptable duration for a non-compete for most types of companies, but remember, what is considered an enforceable duration in a non-compete is a fluid notion. It depends on the type of business.
Tailoring the Agreement to Match the Situation
There is no hard-and-fast rule that applies to every non-compete agreement in every situation. A clause in one non-compete agreement may be enforceable given the circumstances of that agreement, while the exact same clause in another agreement might be found fully enforceable. The difference really lies in the nature of the business. Despite this fluidity, here are some general pointers to guide founders in creating non-compete agreements:
- Keep in mind that non-compete agreements restrict a person’s ability to work; it is not a favored practice to restrict a person from earning a livelihood. Therefore, non-compete agreements are scrutinized to ensure they are reasonable in scope and duration. Make sure your non-compete agreement is reasonable under the circumstances of the industry.
- There is no one-size-fits-all non-compete agreement. The agreement founders reach should reflect the needs of the business, while respecting the rights of the founder.
- All non-compete agreements should discuss the scope of work restricted, the duration of the restriction and the geographic area in which a founder cannot practice his or her work.
- Non-compete agreements can be incorporated into other agreements such as a founder’s agreement, an employment contract or an operating agreement.
Finally, it is prudent to have all founders and integral employees sign a non-compete agreement at the outset of the business relationship. The process of entering into the agreement allows for an open discussion while all parties are on equal ground. Waiting until someone leaves before requesting a non-compete agreement sets the company up for a difficult negotiation. There is hardly any leverage to negotiate a non-compete with one founder on his or her way out the door.
BLOG DISCLAIMER: This blog is provided for general informational purposes only. It should not be construed as legal advice and is not intended to be a substitute for legal counsel. Persons requiring legal advice should retain a properly licensed lawyer. No attorney-client relationship will be formed based on use of this site and any comments or posts to this blog will not be privileged or confidential.
[i] Nat’l Conf. of St. Legislatures, The At-Will Presumption and Exceptions to the Rule, http://www.ncsl.org/research/labor-and-employment/at-will-employment-overview.aspx (last visited Sept. 4, 2015). This is contrasted to a “for cause” employment relationship in which an employer may only terminate an employee “for cause”—for an enumerated reason established via an employment agreement or company policies. Id.
[ii] Please note, non-compete agreements are not accepted everywhere. California, for example, rarely enforces these agreements. Nolo, Non-Compete Agreements: How to Create an Agreement You Can Enforce, http://www.nolo.com/legal-encyclopedia/noncompete-agreements-how-create-agreement-29784.html (last visited Sept. 4, 2015).
[iii] See 52 N.Y. Jur. 2d Employment Relations § 240 (Westlaw 2015).