"My key employee really is vital to my company’s success, but I can’t (or won’t) ask him/her to sign a covenant not to compete. Besides, I’ve heard that covenants not to compete aren’t enforceable."
We often hear owners of closely held businesses grapple with this dilemma. If, however, a basic tenet of building business value is that the best path to growing cash flow is paved by a good management team, we must accept its corollary: Losing management team members is a serious setback to growth.
The Problem
The departure of key employees can harm a company. The hit business value takes from the loss of key people is magnified if they leave and take other employees, customers, trade secrets, and long-term vendor relationships.
The Problematic Solution
The most common tool owners use to prevent a departed employee from harming the business is to put in place an enforceable covenant not to compete. There are two immediate and significant hurdles that make this easier said than done.
First, covenants not to compete restrain people from freely engaging in their trade or occupation. For that reason, they can cause harm to these individuals and their families and courts are reluctant to enforce covenants not to compete.
Secondly, even when covenants not to compete are permitted, many employers are reluctant to present them to key employees (justifiably, as the following case study illustrates) fearing that employees will do exactly what employers do not want—leave.
Sven, an Owner-Based Planning Advisor, recently met with two co-owners of a business to discuss a possible sale of their company. When he learned that they had owned the business for only five years, he was shocked. Their company had over 125 employees, $10 million of revenue, and almost $2 million in annual cash flow.
When Sven asked them how they’d built the company in such a short time, they told him that five years ago, they’d both worked at the same company. They decided they could do a better job if they had our own business, so they left. Thirty of their former employer’s best employees and all its important customers followed. Within a year and a half, their company had over 50 employees and was making good money. When their former employer shut its doors, the rest of its employees and business made the switch.
Sven asked, "Didn’t you have covenants not to compete?"
"Ironically, it was when we were asked to sign employment agreements (that included covenants not to compete) that we seriously began thinking about going out on our own."
Could this happen to your company?
It’s worth noting that covenants not to compete are generally unenforceable when employees are not given fair consideration in return for signing a covenant.
The Hybrid Solution – A Non-Solicitation Agreement and Incentive Plan
Let us suggest a different, more enforceable, and equally effective alternative covenants not to compete.
A Non-Solicitation Agreement
We find that an often-better preventative approach is a Non-Solicitation Agreement (NSA). An NSA allows employees to compete but forbids them from taking company employees, customers, and vendor relationships for a set period of years.
For example, it may not be the least bit harmful to allow a key employee to leave your employ and compete against you provided she cannot:
- Solicit existing customers.
- Take other employees.
- Contact and do business with long-time vendors.
As a general rule, the fewer number of years a former employee is restricted from certain activities, the more likely it is that a court will consider an NSA to be enforceable. Of course, if the term of an NSA is too brief, it does not effectively prevent potential harm. By far the best action to take is to consult with your attorney to see how each issue is handled in your state.
An Incentive Plan
In our case study, Sven wondered whether the two owners would have left their former employer had it offered them sufficient incentives and rewards and made the receipt of the award subject to some form of vesting.
Good question.
It behooves employers to offer employees who play a vital role in the growth and success of a business:
- A substantial benefit if employees stay and continue to grow company value.
- An NSA to prevent them from harming your company should they leave.
We are here to Help!
We strive to help business owners identify and prioritize their objectives with respect to their business, their employees, and their families. If you are ready to talk about your goals for the future and get insights into how you might achieve those goals, we’d be happy to sit down and talk with you. Please feel free to contact us at your convenience.
The information contained in this article is general in nature and is not legal, tax or financial advice. For information regarding your particular situation, contact an attorney or a tax or financial professional. The information in this newsletter is provided with the understanding that it does not render legal, accounting, tax or financial advice. In specific cases, clients should consult their legal, accounting, tax or financial professional. This article is not intended to give advice or to represent our firm as being qualified to give advice in all areas of professional services. Business Enterprise Institute, Inc. is a discipline that typically requires the collaboration of multiple professional advisors. To the extent that our firm does not have the expertise required on a particular matter, we will always work closely with you to help you gain access to the resources and professional advice that you need.
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Any examples provided are hypothetical and for illustrative purposes only. Examples include fictitious names and do not represent any particular person or entity.
