Aside from the obvious (for example, lack of capital, lack of operating history, etc.), one of the most pronounced challenges facing startup and emerging companies is their dependence on one or a few key individuals, whether employees or founders. This is such a common theme for early stage companies that it is almost universally disclosed to potential investors as a "risk factor" in private placement memoranda or similar documentation used when raising capital. Smart business owners and investors who understand this risk often seek to protect the company's interests by requiring that these key individuals enter into covenants not to compete with the company, usually through the form of restrictive covenant agreements.
Covenants not to compete generally contain three components: (1) a time restriction (i.e., the period of time after employment during which the individual is prohibited from competing against the company); (2) a scope of business restriction (i.e., the type of business or industry within which the individual cannot be engaged); and (3) a geographic restriction (i.e., the locations in which the individual cannot be engaged in a competing activity). While the laws governing these covenants vary greatly from state to state, most courts will hold that they are enforceable so long as they are intended to protect the legitimate business interests of the company and they are reasonable with respect to time, scope of business and geography. In other words, they can't be too long, the type of business or industry cannot be too far-reaching and the area cannot be too large.
However, no matter how reasonable the terms of a covenant not to compete may be, it will almost certainly never be enforced by any court in any state unless the company can show that the covenant not to compete was entered into at the beginning of the individual's employment with the company or the company provided the individual with some additional and specific consideration such as an increase in salary, a cash bonus or a job promotion. This "timing" factor was highlighted in an excellent piece authored by John Gotaskie, an attorney in our Pittsburgh office, earlier this year.
John's piece summarizes a recent Superior Court of Pennsylvania case which held that a covenant not to compete entered into by a key salesperson who left his employer to work for a competitor is not enforceable since the underlying agreement was not signed at the outset of his employment and the employer did not provide him with any additional benefits or consideration at the time he signed the agreement. You can also listen to John's podcast on this topic here. Note that last week the Pennsylvania Supreme Court agreed to hear an appeal of this decision, so the final outcome remains open.
Regardless of the outcome, the lesson is fairly straightforward for business owners and their investors. If your state's laws allow non-competes for employees, protect your interests and tie up your key employees with covenants not to compete at the outset of their employment. If you don't, be prepared to pay, whether it is at the time you ask them to sign as an existing employee or in court when you are trying to enforce the covenant because a former employee that used to be a vital team member is now competing against you.
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