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Are Covenants Not to Compete the Best Tool for the Job?

Submitted by John Brown on Mon, 04/18/2016 - 5:00am
Wrench in a pocket image

A common theme running through our articles (and Exit Planning in general) is how important next-level management teams are to maximizing business growth and transferable value. There are plenty of ways to find and retain next-level managers. Less obvious, but no less critical, are the steps to prevent key employees, should they leave the business, from harming a company by taking other employees, customers, proprietary information, or vendor relationships. Mitigating (even preventing) this damage is essential to a successful exit. Few owners or their advisors have addressed this Deal Killer. Trained Exit Planning Advisors address the potential departure of key employees and the harm they can to a company’s key assets.  

When advisors first introduce owners to the idea of protecting their businesses by creating covenants not to compete or non-solicitation agreements, owners are likely to respond, “Sure, this employee really is key to my company’s success, but I can’t (or won’t) ask him/her to sign a covenant not to compete. It would destroy our relationship. Besides, I’ve heard that covenants not to compete aren’t enforceable.”

This response is quite common, but if owners accept that the road to a successful exit is paved with great management teams, then they must also accept that losing management team members along that road, especially near the end, can be fatal. That damage is magnified should those employees leave and take other employees, customers, trade secrets, and/or long-term vendor relationships.

Covenants Not to Compete

The most common tool advisors use to prevent a departed employee from harming a business is an enforceable covenant not to compete. Skilled Exit Planners recognize that there two immediate and significant hurdles to overcome.

The Enforceability Issue. Covenants not to compete restrain a person from freely engaging in his or her trade or occupation. This restraint runs counter to the public policy of most (if not all) states. Public policy favors a person’s right to pursue any lawful employment and enterprise of his or her choice. If not outright prohibited, restrictions or limits on a person’s ability to earn a living are carefully circumscribed. Some states, specifically California, consider covenants not to compete illegal.

Loyalty and the Trust Factor. Even in states that allow these arrangements, many employers are reluctant to present them to their key employees for fear that they will anger key employees. Owners expect employees to see these arrangements, which protect the company from employee actions, as a poor substitute for trust and loyalty. Owners fear that presenting key employees with a covenant not to compete will do exactly what the owner does not want: cause those employees to leave the company!

One BEI licensed member recently described that exact scenario. Let's look at what happened.

The Power of Suggestion

I recently met with two co-owners of a business to discuss the possible sale of their company. Their company had over 125 employees, $10 million of revenue, and made almost $2 million a year in profits. When I discovered that they’d owned the business for only for only five years, I naturally asked, “How in the world did you create such a vibrant business in such a short time?”

“Well, we both worked at the same company for fifteen years. We decided we could do a better job if we had our own business. So we left. We took 30 top employees and all of the important customers with us. Within a year and a half, we had over 50 employees and were making good money. Business jumped again when our former employer shut its door and the rest of the employees and business came our way.”

“Didn’t you sign covenants not to compete?” I asked.

“Ironically, it was when we were asked to sign employment agreements (that included covenants not to compete) that we first began to think about competing! We thought if our boss didn’t trust us, why should we trust our futures to him?”

Could this happen if an advisor were to suggest that their owner/clients should consider such covenants for their key employees? Given the legal hurdles that must be overcome, is it even possible to create enforceable covenants not to compete in a manner that is not offensive to key employees?

With a few significant exceptions, it is.

We suggest the following guidelines:

  1. Make owners aware of the many risks they run if their key employees leave, especially if the employees’ departure occurs close to the owner’s planned exit.
  2. Explain that if properly designed and implemented, measures to prevent a key employee from leaving and harming the company by taking employees, customers, or trade secrets are enforceable.
  3. Suggest that less restrictive agreements—especially Non-Solicitation Agreements and Non-Disclosure Agreements—may be as effective as covenants not to compete, less onerous to the affected employees, and consequently less likely to be challenged or overturned by a state court.
  4. Describe how to offset the potential disadvantages of these agreements by simultaneously initiating an incentive plan that substantially rewards the key employees for staying and achieving stated, achievable performance levels. This can turn a potentially disagreeable confrontation between owner and employee into a win-win conversation.
  5. Recommend appropriate professionals, such as a well-experienced business attorney, to create enforceable plans that benefit the owner and key employee.


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