Closely Held Businesses Can Use Agreements to Protect Value

• Agreements that limit former employees from soliciting customers or disclosing confidential information are critical to protecting the value of a closely held business.

• Restrictive covenants and non-compete agreements are difficult to enforce and must be carefully drafted to assure that they are enforceable. 

• Closely held businesses should rely more heavily on contracts to prohibit solicitation and disclosures.

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Restrictive covenants such as non-compete and non-solicitation agreements are vital to the stability of a closely-held  business. Let’s examine how these agreements can be used to protect the value in the most important drivers of value, the intangible assets in your businesses.

Intangible assets are things like intellectual property, customer relationships, and proprietary information. Businesses can prevent employees or rivals from misappropriating these assets by implementing  effective restrictive covenants.

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I am a lawyer, a certified valuation analyst, and a certified exit and succession planner.  I have worked with the owners of closely held businesses throughout my career.

Contact me if you have questions about valuing your business, developing an exit plan, or implementing the legal bulletproofing necessary to protect your investment.

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Securing these intangible assets is essential in the business world for preserving a competitive edge, achieving long-term success, and increasing a company’s worth.

Are Restrictive covenants Becoming Unenforceable?

The restrictive covenant, however, is under attack from a number of sources. They may be difficult to enforce and in some states unlawful.

There are serious doubts in my mind about how effective the traditional post-employment restriction against competition will be by the end of this decade. A number of states and the Federal Trade Commission want to make them unlawful and unenforceable.

Restrictive covenants such as non-compete and non-solicitation agreements are important to most businesses. Let’s look at how these agreements can be used effectively maintain the value of your business’s true pearl of value, its intangible assets.

As a result, businesses must carefully draft any restrictive covenant or face having it be held unenforceable in whole or in part by a court in the event of a litigated dispute.

How to Define a Restrictive Covenant

Restrictive covenants are contracts that prohibit individuals from engaging in activities that are competitive, like soliciting its clients or employees, for a specified period of time. These agreements are crucial for protecting a company’s intellectual property, customer relationships, and trade secrets from being exploited by competitors.

By clearly defining and enforcing these covenants, businesses can hold onto the competitive edge that the well-drawn restrictive covenant is intended to protect.

An example may be a payroll company that requires its sales employees to sign a restrictive covenant that prohibits them from working for a competitor within the same territory they served for two years after their resignation. The purpose arguably is to ensure that the employees do not take proprietary knowledge or clients to competitors.

Enforceable? It depends on a number of factors, starting with the nature of the work that the ex-employee did. Did he or she have access to confidential and proprietary information? Did the employee bring the customers or learn of their needs as an employee?

Are the identities of the customers or their needs for the product something that can be discovered from publicly available sources. These and many other factors are considered by courts before they will enforce a restrictive covenant.

Overview of limits on restrictive covenants

You have to distinguish between confidentiality and non-disclosure agreements and more general agreements not to compete. These later contracts, referred to as restrictive covenants, limit the former employee or owner’s ability to work for a competitor.

Business owners often see these agreements as critical to preserving the company’s brand, its customer relationships and prevent the loss of its valuable business information.

But it’s important to note that restrictive covenants are subject to a number of challenges and may be unenforceable. In those state where they are enforceable, there are limitations and restrictions.

At a minimum the post-employment restriction must be tied to protecting a legitimate interest — and that does not include preventing competition in general — and must be reasonable as to the geographic scope and duration.

For example, a software company may require its employees to sign a non-compete agreement to prevent them from working for a direct competitor within a certain radius for a specified period of time after leaving the company.

However, if the agreement is too broad in scope or duration, it may be deemed unenforceable by a court. An agreement that prohibits employees working for any similar employer anywhere in the country for 10 years would likely be considered reasonable in both geographic scope and duration, making it unenforceable in court.

Are Restrictive Covenants Effective at Protecting a Business from Unfair Competition?

There are a number of academics who now argue that the traditional restrictive covenant really does not protect a business from loss of its intellectual property.

They argue that rather than preventing unfair competition, restrictive covenants actually hinder innovation and inhibit employees from using their skills and knowledge to their fullest potential.

One position is that restrictive covenants restrain trade in the labor market and are used indiscriminately to significant cost to the economy.

There is also the view that a positive workplace culture and adequate wages do more to prevent defections and the loss of intangible assets that non-compete agreements with employees are intended to protect.

The majority of research, according to economist Evan Starr of the University of Maryland, is that the use and enforceability of noncompete agreements lowers wages, entrepreneurship, and job-to-job mobility. This makes it more difficult for businesses to hire new employees and having a negative knock-on effect on other players in the market.

Can Employers Achieve the Same Results with Non-Solictation and Confidentiality Agreements?

Non-solictation agreements will be examined by courts, but in my view, they are more likely to be enforced to the extent that they prohibit the former employee from soliciting the clients of the firm that the employee personally served. Particularly, if they became known to the employee during their employment.

Courts are far more solicitous of attempts by businesses to protect specific customer relationships. This may be particularly true when the former employee is going after clients of their former firm that they served personally.

Confidentiality agreements may be the most effective tool against unfair competition. They are not subject to time or geographic limitations, and there is a well-defined body of law that protects business owners’ interests in their trade secrets.

And while the scope of trade secrets law and confidentiality agreements may be limited to non-public proprietary information, that is generally the same interest that most businesses are trying to protect with their non-competes.

Using trade secrets to prevent unfair competition requires planning, but it can be extremely effective. The business must make the effort to identify the information that it was protecting and to put in place policies and procedures to keep the information private.

Nonetheless, an effective trade secret enforcement program will protect against the loss of customer information, pricing information, proprietary processes, and most other information that can be unfairly used by a competitor.

In Need of a New Jersey Business Law Attorney?

If you have questions about restrictive covenants such as non-compete and non-solicitation agreements in New Jersey, please contact our business law attorneys today.