What founders need to know about FTC’s proposed ban on noncompete clauses

Restrictive covenants are one the most controversial topics you might negotiate with your employees, if you are a founder. It may also be one of the most personal contractual provisions you will negotiate for yourself as a founder. And, the laws concerning noncompetes are evolving drastically — making it even more challenging to ensure that the restrictive covenants in their startup documents are enforceable.

The use of noncompete agreements across US industries is not new. The US Government Accountability Office recently cited that approximately one in five workers in the country are subject to a noncompete agreement. Below, we clarify what exactly is a noncompete agreement and flag a few elements to be mindful of to successfully run your business without the risk of violating a noncompete (or without violating the evolving rules concerning noncompetes). We also explore the controversy regarding noncompete enforcement to preview what role these contracts may play in the future.

Navigating these issues takes creativity, knowledge and adaptability — and ultimately, these new regulations, which are restricting companies from using noncompetes as freely, may shape how startups protect their proprietary information and innovative technologies going forward.

What exactly is a noncompete agreement?

A noncompete agreement is a contractual term that prevents one party from pursuing certain competitive business activity with another.

They arise in many circumstances, but predominantly in the employment context, in which an employee agrees that both during and after the end of the employment period, they will not compete with his or her current or former employer. The agreement is often limited to a certain geographic scope and specific period of time. Specific parameters can vary greatly across industries and states, and even among employees of the same company.

A noncompete agreement is a contractual term that prevents one party from pursuing competitive business activity with another.

In most US jurisdictions, to be enforceable, the agreements must meet certain criteria, including that they be supported by consideration, meaning that the employee must receive something of value in return — a bonus, equity, a promotion, or, in some cases, the initial offer of employment itself — for promising not to engage in competitive business activity upon leaving.

A noncompete agreement may be presented as part of an employment contract, a separate equity or bonus agreement, or contained in a standalone contract present either along with an offer of employment or later during the relationship. It also may be included among other restrictive covenants, including confidentiality of trade secret agreements (which prevent the disclosure of business information) and non-solicitation agreements (which prevent employees from hiring away former colleagues or pursuing their company’s customers).

If you are not sure whether or not you are subject to any noncompete clauses, you should review your previous employment contracts and offers and look for terms like “noncompete agreement” or “covenant not to compete.” Review the terms carefully because, as explained below, companies for which you worked may enforce these agreements strictly if they feel like their business may be threatened by your post-employment endeavors.

How do I know if a noncompete clause is enforceable?

One of the most important questions to consider in determining how to handle a noncompete is whether or not the agreement is enforceable – that is, whether or not the company can go to court to prevent you from violating its terms. But take note, even in ambiguous or controversial cases, little prevents a former employer from taking an aggressive approach, and seeking to enforce an agreement though you may disagree to the extent of its reach.

Under the law, enforceability of noncompete agreements varies greatly across the country. State law in California, North Dakota, and Oklahoma has effectively banned such agreements in the employment context, while Illinois, Colorado, Massachusetts, Minnesota, and many other states strictly limit their use. In locations where such agreements can be offered and enforced, determining whether or not a noncompete agreement is permissible turns largely on whether its scope is reasonable. That includes consideration of both of the following questions:

• Whether the restraint is broader than needed to protect the employer’s legitimate business interest?
• Whether the employer’s need for the noncompete clause is outweighed by the hardship to the employee or public interest?

States define “legitimate” business interest in different ways, but each state restricts noncompete clauses to some degree. Common legitimate business interests have included:

• Intellectual property, such as trade secrets or patents
• Confidential business information
• Current or prospective company relationships with specific customers or clients
• Specialized employee training and development

A party seeking to enforce a noncompete will need to demonstrate that the agreement does not prevent the affected party from earning a living in his or her chosen field. The law in some states have also impose restrictions based on industry and other employment metrics. For example, noncompete agreements against physicians are not enforceable in some states because of a legislative determination that the public’s need for medical services outweighs the employer’s interests in preventing competition. In several states, employers are also limited from using noncompete agreements for low-wage earners.

When an employer suspects that an employee or former employee is in violation of a noncompete agreement, they may contact the employee or his or her employer to ensure that they take the risk of breach seriously, including by threatening court action to force compliance if they think it is appropriate. If an employer can prove that a breach has occurred or will, the court can grant an injunction to prevent the employee from engaging in any action that would violate the agreement. An injunction could halt a competing entrepreneur’s business operations or even prohibit an employee from taking on a new job. A court may also force the employee to pay damages, such as fines, or force them to surrender profits derived from the violating conduct.

What’s on the horizon for noncompete agreements?

In recent years, the enforceability of noncompete agreements has become a hot button political issue. The Federal Trade Commission has gone so far as to claim that, in nearly all cases, they are harmful to competition. As it pertains to entrepreneurship, the FTC claims that noncompete clauses prevent “would-be entrepreneurs” from starting new ventures and inhibit workers from presenting ideas to new companies.

In January 2023, the Commission published a proposal to ban noncompete clauses. The FTC cites various studies that argue, among other things, that noncompete clauses increase the risk of entrepreneurship by making it harder to hire talent with relevant experience and diminish the value of intellectual property. The FTC further argues that noncompete clauses discourage innovation by preventing workers from starting businesses in which they can pursue innovative new ideas.

Scope of the rule: Who does it apply to?

If passed, the rule would only apply to clauses between employers and workers, not between two businesses where neither is considered a worker. Worker is defined as “a natural person who works, whether paid or unpaid, for an employer”; it includes independent contractors, externs, interns, apprentices, sole proprietors who provide services to customers, and even volunteers. Employer refers to any natural person, partnership, corporation, association, or other legal entity acting under the authority of state law, that hires or contracts with a worker to work for the person.

How would the rule function?

The new rule would establish that it is an unfair method of competition for “an employer to enter into a noncompete agreement with a worker, maintain a noncompete agreement with a worker, or tell a worker that they are subject to a noncompete clause without good faith that the clause would be enforceable.” Although the rule would not apply retroactively, meaning employers would not be punished for noncompete agreements entered into in the past, if passed, the rule would require employers to rescind existing noncompete clauses entered into before the compliance date. Employers must then notify the worker that the agreement is no longer in effect within 45 days.

Exceptions

There is a narrow exception for noncompete clauses between the seller and the buyer of a business where the party restricted by the noncompete clause is an owner, member, or partner holding at least 25% equity in the business entity. The Commission proposed a threshold of 25% to consider instances where entrepreneurs sharing ownership interest in a startup sell their firm. The ban on noncompete agreements would not extend to nondisclosure agreements and trade secret law, which the FTC views as less restrictive means of protecting valuable investments.

Enforcement

This rule would supersede any state statute, regulation, or interpretation that is inconsistent with its provisions. The proposed rule operates as a floor, meaning states will be able to impose stricter restrictions against noncompete clauses, but nothing less protective. The FTC is expected to vote on the final version of the rule in 2024. The proposed rule would go into effect 60 days after it is published in the Federal Register. Businesses will need to comply with the rule within 180 days after publication.

The comment period ended in April 2023. Not all commissioners agreed with the new rule. Former Commissioner Christine Wilson pointed out that the studies relied on in the proposal have contained mixed results and provide insufficient support for a widespread ban. The FTC’s own proposal acknowledges that studies also exist that demonstrate that noncompete clauses have no significant impact on new business formation.

Ultimately, while noncompete agreements may present challenges to business formation, they also support the generation of unique ideas and encourage greater design thinking. It’s important to be mindful of any noncompete agreements you may be subject to, but with planning and ingenuity it should not stall your startup.

How can noncompete agreements spur entrepreneurship?

We see a variety of ways:

• Product innovation — Enforcing noncompete agreements forces workers to be innovative because instead of simply recreating their former employer’s enterprise, entrepreneurs will be encouraged to add value to products or services, or creating new offering altogether, potentially by using or creating new technologies and designing or leveraging new materials to sufficiently distinguish their ventures.
• Identify gaps in the market — Having to work around a noncompete agreement can create an opportunity for former employees to identify unmet consumer demands in industries with which they are familiar. Identifying gaps in the market can help to generate ideas for a new business.
• Product market expansion — The geographic scope of a noncompete agreement can force an entrepreneur to bring their idea to a new region. Leaving the region can expose an entrepreneur to new markets which will encourage them to tailor their business or ideas to the needs of a new community.
• Spinoffs — A spinoff occurs when a subsidiary of a public company becomes its own separate company. Spinoffs have become a widely recognized form of entrepreneurship in the high-tech manufacturing industry. One study found that enforcing noncompete agreements improves social welfare outcomes by stimulating spinoff entry and enabling the original company to capture a portion of the profit.
• Develop leadership skills and market expertise — While many argue that noncompete agreements only benefit the employer, they benefit entrepreneurial employees as well. Many employees already have business ideas but may not know how to get their start-up off the ground. A noncompete clause enables a business to hire talent without the concern that the employee will later use the confidential knowledge and resources that they gained to compete with it, at least for some time. In exchange, employees can learn from these businesses and gain the leadership skills and organizational understanding necessary to start their own enterprises.

So long as companies continue to comply with reasonable noncompete agreement standards, the American economy will continue to find ways to build and innovate new enterprises. Signing a noncompete agreement does not mean sacrificing your entrepreneurial ambitions!

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Kim’s Korner is a series of articles by Ballard Spahr’s emerging company and venture capital attorneys. The column is not legal advice. The substance of the column is derived from our experience working with founders and details many of the current critical issues facing startups.

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