NEWS & ARTICLES

FROM BARBER BRIEFS E-NEWSLETTER · WINTER 2011


Covenants Not To Compete: An All-Or-Nothing Bet for Small Businesses
BY JOSEPH F. KOLB

You operate a small business.  You’ve spent three years and your life savings developing a customer base, or capturing a market share, or developing a business process that gives you a competitive edge.  You’re considering hiring a new employee or bringing in an equity partner to expand your business.  But you’re afraid that your new hire – or worse yet, your new partner - will stick around just long enough to learn the business, then quit and open his own shop down the block.  What do you do?  How do you protect your business from an employee or partner who may be eager to profit from your hard work – somewhere else?

Non-compete agreements or “covenants not to compete” may be an answer.  They are one way you can attempt to limit what employees or partners can do with certain information, specialized training or processes they learn on the job.  But you should be aware that not all non-compete agreements are enforceable.  There are specific requirements.  And there are limitations.  Care must be taken to draft them in such a way as to comply with the requirements of Arkansas law.  Or they could be wholly unenforceable.  Here’s an overview of what you need to know.

As a concept – though perhaps not so much as actual business owners – we Americans value the free-market notion of competition as much as anything.  It’s right up there with mom, football, and apple pie.  So it should be no surprise that non-compete agreements have generally been disfavored by our courts.  Early on, judges recognized that public policy favors competition and will not allow someone to simply buy off potential rivals.

As a result, courts originally presumed non-compete agreements to be invalid and uniformly declared them unenforceable.  Their position softened over time, however.  Now courts in Arkansas hold that the presumption that a non-compete agreement is an impermissible restraint on trade can be overcome if you show that the agreement is “reasonable.”

So how do you determine what is “reasonable?”  It depends on the facts and circumstances of your case.  Lawyer-speak, right?  Well, fortunately the courts have articulated at least four clear requirements. 

First, for a non-compete agreement to be considered reasonable, you must have a legitimate business interest to protect.  That interest must be more than just a desire to prevent someone from competing with you.  A non-compete cannot provide you protection from ordinary competition.  In other words, it’s okay for an employee to use at her next job the general experience and knowledge she gained while working for you.  That experience and knowledge are not your property.  If, however, you have entrusted her with something more than just general experience, you have a right to protect it.  For instance, if you’ve given her access to your trade secrets, confidential information, specialized training or special influence over your customers, you have a legitimate business interest to protect.

Second, the business activity you are attempting to restrain must be in direct competition with your business.  If you use a non-compete clause to attempt to restrict the right of an employee or former partner to engage in a mere complementary business, it will be held unreasonable and, therefore, unenforceable.  For instance, if you’re a pencil manufacturer who only sells your wares at wholesale, you cannot restrict your former partner from starting a business to sell pencils at retail.  That would be an unreasonable restraint on trade.

Third, the duration of a non-compete agreement must bear some rational relationship to the length of time the business interest you’re trying to protect has value. Let’s say, for example, your goal is to prohibit an employee from leaving and going to work for your chief competitor with a detailed customer list that took you years to develop.  The key question will be, at what point in time will that customer list loose the greatest part of its value in terms of giving you a competitive advantage.  The duration of your non-compete should correspond to that period.   A court will declare a longer duration unreasonable.

Fourth, the geographic scope of your agreement must also bear some rational relationship to the business interest you’re trying to protect.  If the company you’re buying does business exclusively in Arkansas, but the non-compete in your buy-sell agreement prohibits your seller from starting a competing business in Missouri, your agreement will likely be deemed unreasonable.  Why?  Because you have no legitimate business interests to protect in Missouri.

So here are the take-aways.  To be enforceable, a non-compete agreement must:

  1. Relate to a legitimate business interest – something more than just a general desire to limit competition.
  2. Restrict only business activities in direct competition to yours.
  3. Be reasonable in duration.
  4. Be reasonable in geographic scope.

Here’s the catch.  Covenants not to compete are all-or-nothing bets.  If a court finds that the time period of your agreement is unreasonable, or the geographic scope is too broad, it will declare the non-compete wholly unenforceable.  It will not rewrite an agreement to make it enforceable for a shorter period or in a smaller area.  So it is essential that you get it right the first time.

A non-compete can be a valuable tool to protect your small business from folks seeking to profit from your hard work - or it can be a complete bust.  The key is to know how to draft one.

Joseph F. Kolb is a member of the Business and Corporate Law Practice Group at the Barber Law Firm. He can be reached at jkolb@barberlawfirm.com.

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