What is a Covenant Not To Compete?

A covenant not to compete, or a non-compete clause, is an agreement in which one party agrees not to work for the other party’s direct competition in a specified area for a certain amount of time. While a covenant not to compete is generally found in an employment contract, it can be found in contracts for the sale of a business as well.

Do covenants not to compete vary by state?

While courts do not like covenants not to compete because they restrict competition, courts will often enforce them if the covenant meets certain legal standards. Each state has its own laws, which determine an enforceable covenant not to compete. However, while some states define an enforceable covenant not to compete more narrowly than other states, most follow similar criteria in determining whether the covenant is legally enforceable.

Covenant not to compete in employment

In the employment agreement context, an enforceable covenant not to compete must generally protect a legitimate business interest of the employer. However, this does not mean that an employer may prevent the employee from working for a competitor, just because there will be a loss of business for them. In order for it to be a reasonable restriction, the employer must have specific business interests at stake, such as the prevention of their competition learning their trade secrets. Customer relationships may also be considered a legitimate business interest. This means that a covenant not to compete may legally prohibit an employee from bringing the current clients from their old job to their future employer as new customers. As with any enforceable contract, a covenant not to compete must also be supported by consideration. When an employee signs a covenant not to compete before they begin their employment, the employment is the consideration.

When a covenant not to compete is signed after employment, it also must be supported by adequate consideration, such as a promotion. Finally, a covenant not to compete must not unduly burden the employee’s right to make a living. This means that the covenant must be reasonable in its scope and duration of time. For example, if a covenant not to compete denies the employee the right to work for any competitor in the regional area, a court is more likely to find that this covenant is more reasonable in its geographic restrictions than one that denies the employee the right to work for any competitor in the entire United States. However, the territorial scope can vary greatly depending on the employee’s type of business or industry.

Covenant not to compete in the sale of a business

A covenant not to compete may also appear in some contracts for the sale of a business. In these circumstances, the buyer will have the seller sign an agreement that states that they will not open a competing company within a regional area, within a specific period of time.

Generally, a legitimate business interest will also make a covenant not to compete enforceable in the context of a sale of a business. Further, courts tend to construe this more liberally in these types of contracts than they do in the employment context. These covenants must also be reasonable, however, and not unduly infringe on the seller’s right to make a living.

Case Studies: Enforceability of Covenants Not to Compete

Case Study 1: Software Development Company

A software development company includes a covenant not to compete in its employment contracts. The covenant prohibits employees from working for a direct competitor within a 50-mile radius for a period of two years after leaving the company.

The company argues that the covenant is necessary to protect its trade secrets and customer relationships. However, a former employee challenges the enforceability of the covenant, claiming that it unduly restricts their ability to find employment in the industry.

Case Study 2: Restaurant Franchise

A restaurant franchise agreement includes a covenant not to compete that prevents franchisees from opening a competing restaurant within a 10-mile radius for five years after selling their business. A franchisee decides to sell their restaurant and later wishes to open a new restaurant in the same area.

The franchisor argues that the covenant is necessary to safeguard the brand and protect the interests of existing franchisees. The franchisee questions the reasonableness of the covenant and seeks legal advice on its enforceability.

Case Study 3: Medical Practice Acquisition

In the context of a medical practice acquisition, a purchasing entity includes a covenant not to compete in the agreement with the selling physician. The covenant prohibits the physician from practicing medicine within a 30-mile radius for a period of three years after the sale.

The selling physician expresses concerns about the restriction, fearing that it may limit their ability to continue practicing in the local community. They consult with a lawyer to determine the validity of the covenant and explore potential alternatives.

How can you get legal help?

If you have further questions about a covenant not to compete or you would like to learn about the particular laws in your state, you should consult an experienced business attorney for more information.