Key Employees and Covenants Not To Compete

Part Two: The Solution

In our last issue, we looked at the thorny problem that faces owners who have key employees but who have no way of preventing them from competing (or taking other employees or customers) should they leave the company.

Given the two hurdles that need to be overcome,

• Restraints or restrictions upon one's ability to earn a living are limited and, in many cases, prohibited; and
• Even when permitted, many employers fear that when they present their key employees with a written covenant not to compete they will become angry and do exactly what the owner does not want--leave the company!

Our question was: Is it possible to create enforceable covenants not to compete in a manner that is not offensive to your key employees who will be asked to sign them?

Our answer is: Yes, in most states, if you follow the very specific guidelines laid out in your state's case law. For that reason, you must check with experienced legal counsel in your state to determine the conditions under which, if any, covenants not to compete are enforceable. In most, but not all, states, covenants not to compete are generally unenforceable except or unless they meet certain rather narrow exclusions-exclusions, which often apply to key employees and management.

First Exception

Covenants not to compete are often permitted and enforceable if they are entered into by management where the covenant is reasonable with respect to:

• The scope of the prohibition;
• The duration of the prohibition; and
• The geographical territory encompassed.

Each of these three standards is usually subject to numerous State Court rulings and interpretations. It is this case law that guides your attorney when drafting covenants for your employees.

Scope
You and your attorney must attempt to determine what a particular management employee can do to harm your business should he or she leave it so that the agreement is not so broad as to be prohibited. Once you have identified specific threats, your attorney will draft a covenant that prevents that employee from doing that harm.

For example, it may not be the least bit harmful to allow a management employee to leave your employ to compete against you provided she cannot:

• solicit existing customers;
• take other employees; or
• contact and do business with your treasured vendor relationships.

Duration
As a general rule, the shorter the term of the covenant, the more likely it is to be considered enforceable. Of course, if a covenant not to compete is too short in duration, it does not effectively prevent competition. If the covenant restricts activities longer than two to three years, courts may question its "reasonableness." Like every other exception described in this newsletter, consult with your attorney to see how each issue is handled in your State.

Geographical Territory
You and your advisors must also determine the geographic scope in which it is appropriate to prohibit competition. For example, if your business is geographically quite concentrated, an effective covenant might restrict a particular management employee from doing business within that limited area (perhaps the county in which your business is located or a surrounding geographical area) rather than in the entire state in which you are located.

As you wrestle with determining what is "reasonable," you can reasonably expect courts to be less inclined to strike down a covenant not to compete when the employee can still engage in his trade or profession.

Second Exception

Neither courts (nor your key employees) will favor covenants not to compete unless key employees receive valuable consideration in return for signing. When you think about incentive programs to motivate and keep your key people, consider that the additional money or value provided by that incentive program may well be sufficient consideration to satisfy both your key employees and your state's courts should a subsequent dispute arise.

Third Exception

Another exception to the general rule prohibiting covenants not to compete is to include a covenant not to compete as a condition of ownership in the business. For example, if the two key employees described in the last issue of this newsletter (For a copy of the previous issue, please send your request to cviviano@claytoncapitalpartners.com.) had been granted (or they had purchased) ownership in their original employer and along with that ownership signed reasonable covenants not to compete, their ability to leave--and in effect bankrupt their former employer within 18 months--could have and would have been prevented in the state in which they lived and worked.

Your state's statutes and common law might well provide you with greater protection and assurance of the covenant not to compete if accompanied by stock ownership. (Did we mention that you should check with your attorney?)

Further it is entirely possible that had sufficient incentives and rewards been offered to our two key employees, especially subject to some form of vesting, they might never have left.

When you have key employees who are critical to the success of your business, and even more importantly, critical to your successful business exit, it behooves you to offer:

• a substantial benefit if they stay (and continue to grow company value) and
• a narrow but entirely adequate bar to harming your company should they leave.

These two concepts work best in tandem, and, perhaps only in tandem.

Subsequent issues of The Exit Planning Navigator® discuss all aspects of Exit Planning. If you have questions, please contact Kevin Short, Managing Director.