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Covenants Not To Compete: Protection for Your Business

Are you concerned that one of your best employees will leave to join a competitor? Your worries may be eased if the employee signs a “covenant not to compete” as part of an employment agreement. The covenant (also called a “non-compete clause” or “non-compete agreement”) is enforceable against a departing employee as long as certain conditions are met.

Usually, an employer requires employees to sign the covenant as a pre-condition of employment. But it may also be used as a release for an employee to receive severance pay after termination of employment or pursuant to the sale of a business or issuance of stock options. Caution: The covenant cannot be overly restrictive. For instance, your company generally can’t prevent a former employee from pursuing a living anywhere in the same industry.

Long Tax Write-Off For a Short Covenant

According to Section 197 of the Internal Revenue Code, the cost of acquiring an intangible business asset must be amortized over a 15-year period. This tax rule generally applies to a covenant not to compete.

One case: An individual owned 23 percent of a Massachusetts business that provided consulting and management services to insolvent companies. He informed the president that he wished to leave the company and have his shares bought out. He agreed to a $400,000 payment for a covenant not to compete as part of an $805,000 buy-out of his share. This agreement covered a period of twelve months spanning two calendar years. The company’s accountant calculated and allocated the $400,000 payment for the covenant over the two-year period.

According to the Tax Court, the non-competition payment prohibited him from engaging in competitive activities for a one-year period and was comparable to his annual earnings.

Although the company argued the 23 percent interest was not substantial and was outside the reach of Section 197, the Court held that it was. Judges ruled that the covenant arose out of the acquisition of a business interest. Therefore, the 15-year write-off period under Section 197 applies, even though payments were made over just two years (Recovery Group, Inc., TC Memo 2010-76).

Also Used in Business Sales

Non-compete clauses are also likely to be used in contracts when a business is sold. Basically, they prohibit the seller from starting a competing business, since it would take customers or clients away from the one being sold.

The terms vary but typically describe the time period, the types of businesses that are involved, and the geographic area. As with covenants signed by employees, these agreements should not be overly restrictive. For example, you should not restrict a seller from starting any type of business for the next 25 years since courts would look at the agreement as harming the individual’s ability to earn a living.

Laws regarding non-compete covenants vary from state to state. For example, courts in California generally reject non-compete agreements because state law makes them unenforceable except in limited circumstances. Because non-compete covenants are generally not allowed in the state, California employers often use confidentiality agreements and other types of contracts to protect trade secrets and other information.

Still, in many jurisdictions, non-compete covenants can be enforceable if certain conditions are met.

In order for a non-compete covenant to be legally enforceable, it must be in writing, part of a contract and an employer must be able to demonstrate the following:

1. The agreement is supported by “consideration” at the time of signing. In essence, this means that the employee must receive something in value in return for the promise not to compete. When a covenant is signed prior to hiring, the employment itself is the “consideration.” However, if an employee signs a covenant not to compete upon termination, it generally requires some form of severance or other benefits.

2. The agreement protects a bona fide business interest. Although the exact definition of a legitimate business interest is controlled by state law, this requirement usually reflects the need to retain valuable customer relationships and/or to shield proprietary information from the competition. For instance, a covenant not to compete may prohibit an ex-employee from soliciting the company’s main clients. Similarly, the covenant may prevent a departing employee from revealing vital information about the company’s business model. Note: An employee already has a duty not to disclose proprietary information, but the covenant makes it easier to enforce.

3. The agreement must be reasonable in scope. The third requirement is more difficult to pin down and often results in disputes that proceed to the courts. The outcome generally depends on the specific services provided by the employer and interests that are at stake. For example, a court is unlikely to restrict an ex-employee from working in a geographic area where the employer doesn’t do business, although limitations may be imposed if the employer has clients in those areas. The duration of the agreement is also a key factor. If the covenant extends no longer than one year, it is usually acceptable to the court. Between one and three years, it depends on the circumstances. Beyond three years, it is supect.

Example of one company winning in court: Timothy Rinn signed a covenant not to compete as part of a stock option agreement while he was employed at The Selmer Company, a Wisconsin construction contracting firm. He was promoted to director of business development, where he served as the liaison between the company and its customers.

The non-compete provision Rinn signed stated that for one year after leaving the company, he would not contact or solicit customers from The Selmer Company or divert business from the firm.

Rinn left the company to work for Ganther Construction Inc., another full-service contractor. In the first month, according to court documents, Rinn sent at least a dozen letters and made several telephone calls to Selmer’s former and prospective customers. Rinn told each he had left Selmer and was working with Ganther. He also remained on the boards of directors of Selmer’s customers.

Selmer sued Rinn and his new employer, seeking injunctive relief and compensatory damages. Rinn argued that the non-compete covenant was “overly broad and unenforceable” under state law.

However, the Wisconsin Court of Appeals ruled in 2010 that the covenant was reasonable because it was necessary to preserve Selmer’s customer base and it only restricted Rinn’s solicitation of the customers of his former employer.

“Rinn is free to use his skills, ability, and experience — but not his knowledge of or relationships with, Selmer’s customers – in other similar work,” the court stated. In addition, the covenant only restricted Rinn’s activities for one year and he was free to walk away from signing the stock option agreement.

“In exchange for Selmer’s promise to make discount stock available,” the court noted, “Rinn forfeited his ability to tap Selmer customers for one year following his employment.” (Selmer Company v. Rinn, Wisconsin Ct. of Appeals, No. 2009AP1353)

When a legally enforceable covenant is breached, the court may issue an injunction against the employee, prohibiting any further action. It may also assess damages for losses caused by the breach.

Remember that an employer is usually in a stronger bargaining position before employment begins. Include this type of covenant in employment agreements, especially with high-profile employees, for greater protection. Consult with your attorney about agreements with your company’s or organization’s employees.