Non-Compete Agreements and Their Enforceability
A non-compete agreement is an agreement or a provision in an agreement that prohibits one party from engaging in certain business activities. Non-compete agreements typically arise in employment agreements, partnership agreements, business buy/sell agreements and franchise agreements where they prohibit one party from establishing, operating and/or working for a competing business. Non-compete agreements are highly scrutinized by courts and their enforceability depends on the relationship of the parties, the language and nature of the agreement giving rise to the non-compete, and state specific law.
Situations that may require a non-competition agreement to be signed include:
- At-Will Employment relationship
- Vendor Relationship
When evaluating a non-compete, its enforceability, and the strategy right for you, start off with an assessment of the contractual rights and factual circumstances giving rise to the non-compete. To be enforceable non-compete agreements must serve a legitimate business purpose, and be reasonable. In evaluating the legitimacy of a business purpose and the reasonableness of the non-compete, courts will evaluate the agreement and relationship that gave rise to the non-compete, for example, is the non-compete the result of an employment relationship, a shareholder / partnership relationship, or a business relationship?
What Is The Reason For Your Non-Compete?
Start off with an evaluation of why the non-compete agreement was signed. Typically, non-competition agreements and the threat of enforcement and litigation relates to either:
- An employment relationship with an employment agreement that contains a "non-competition" covenant;
- A partnership relationship where, under the terms of a shareholder, partnership, or member operating agreement, the partners are subject to non-compete covenants;
- A business buy/sell agreement where the selling party and its owners are subject to post-closing non-compete covenants; or
- A franchise relationship where a franchisee is subject to non-compete covenants during the term of the franchise agreement and for a period of time following the termination or expiration of the franchise agreement.
In most states non-compete agreements are heavily scrutinized and enforceability varies depending how the non-compete was drafted and the particular circumstances. Below is a summary of typical non-compete relationships and the enforceability of non-compete agreements:
NON-COMPETES AND EMPLOYMENT RELATIONSHIPS (Lower Enforceability) - In many states non-competition covenants and obligations created as a result of an "employer - employee" relationship face extreme scrutiny. Within this employer relationship, a distinction must be made between "contract employees" and "at-will" employees.
- At-Will Employees - At-will employees are employees who possess no contractual rights to continued employment. That is, there is no agreement that prohibits the employer from terminating an "at-will" employee. In contrast to an at-will employee is a “contract employee” who is guaranteed employment for a specific period of time and where he or she cannot be terminated he or she breaches the employment agreement. Enforcing a non-compete agreement against an “at-will” employee is more difficult than enforcing against a “contract employee”. The reason is simple - it’s because the at-will employee has no contractual employment guarantees and enforcing the non-compete may deprive him or her from earning a livelihood.
- Contract Employees - For contract employee, unlike at-will employees, courts are more likely to enforce non-compete agreements. Of course, enforcement will also depend on issues of fairness and facts related to the contract employee’s termination, whether or not the contract employee will receive compensation during the non-compete period and the overall drafting of the actual non-compete agreement.
PARTNERSHIP RELATIONSHIPS (Moderate Enforceability) - Unlike employment relationships, non-competes between business partners are more likely to be enforced and, many times, are supplemented by state law that creates a fiduciary duty and obligation between business partners. Non-compete obligations between business partners are typically contained in the partnership, shareholder, or member operating agreements between the parties.
BUSINESS TRANSFERS AND SALES (High Enforceability) - Many business buy/sell agreements - related to the transfer and sale of a business - include post-closing non-competition covenants and obligations. These obligations and covenants, although not guaranteed, are likely to be enforced by courts.
FRANCHISE AGREEMENTS (High Enforceability) - Non-compete restrictions are necessary obligations to impose on a franchisee when dealing with a franchisor-franchisee relationship. A franchisee will be given access to a franchisor’s confidential operations manual and systems and will be operating a franchised outlet under the franchisor’s brand name. As such it makes sense that during the term of the franchise agreement (i.e., while the franchisee is still a franchisee and is operating the franchised outlet) that the franchisee be prohibited from establishing or operating a competing business. Likewise, to protect the franchisor’s intellectual property and the rights of other franchisees, it also makes sense that in the event of an expiration or termination of the franchise relationship that a franchisee, likewise be subject to a non-compete. Accordingly, non-compete agreements are enforceable when dealing with franchisees and this is especially the case during the term of the franchise relationship. Upon expiration or termination of the franchise relationship, enforceability of a non-compete will depend on the language used to create the non-compete and whether or not the scope and time period of the non-compete appears to be fair and reasonable.
When evaluating non -compete agreements and their enforceability, everything will depend on your goals and the facts that give rise to questions of enforceability. If you are a franchisor, plan out your franchisee non-compete provisions and non-compete provisions for key management and sales level team members.
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