How Non-Compete Bans Impact Startups: Federal Proposed Rule & State Specific Limitations

Non-competition clauses are under scrutiny at the federal level and in some states with governments taking a more pro-labor stance against restrictive covenants. In July 2021, President Biden issued an executive order directing the Federal Trade Commission (FTC) to exercise the agency’s statutory rule-making powers to “curtail the unfair use of non-compete clauses and other clauses or agreements that may unfairly limit worker mobility.”

In January 2023, the FTC announced that it is entering the rule-making process for a rule that would ban non-competition agreements between employers and employees at the federal level. Currently, non-competition law is governed by each state’s specific employment laws, so a federal rule would have sweeping effects over the existing legal landscape. Oftentimes, if the company does not already have non-competition agreements in place with its service providers, then, in connection with a preferred stock financing, venture capital funds may require that the company enter into non-competition agreements with their employees if permissible under the applicable state law. Therefore, this proposed rule could have implications on venture capital financing negotiations around post-closing covenants for restrictive covenant agreements. 

What exactly is the FTC proposing to do in order to ban non-competition agreements? The proposed rule would generally prohibit employers from using non-competition clauses in service agreements with workers by making it illegal for an employer to:

  • enter into or attempt to enter into a non-competition agreement with a worker;
  • maintain a non-competition agreement with a worker; or
  • represent to a worker, under certain circumstances, that the worker is subject to a non-competition agreement.

The proposed rule includes a narrow exception for a non-competition agreement entered into in connection with an eligible sale-of-business transaction. This exception would permit a non-competition agreement to be enforceable against persons holding at least a 25% ownership interest in the business entity involved in a transaction. 

The proposed rule would also require that employers rescind all existing non-competition agreements by a date to be determined by the FTC and provide notice to current and former workers (that are subject to a non-competition agreement) informing the workers that the non-competition agreements are no longer enforceable. The term “worker” is proposed to be all-encompassing, including without limitation, an employee, independent contractor, intern, volunteer, apprentice, or sole proprietor who provides a service to a client or customer. The public comment process closed on April 19, 2023. The FTC will now review all comments received and conduct a comment analysis. Then, the FTC will decide whether to proceed with the rule-making process, issue a new or modified proposal, or withdraw the proposal. 

In light of the federal proposed rule, we prepared the below chart summarizing the non-competition laws that apply in some of the common US labor markets for startup employers. 

State Standards Considerations Statute/Law
California Non-competes are generally illegal and unenforceable under California law. One exception is that owners of the business may be subject to non-competition agreements in connection with the sale of the company. Startups should avoid non-competition agreements with CA employees in the ordinary course. Startups can implement other restrictive covenants to prohibit the employee from using the company’s trade secrets. Cal. Business & Professions Code §§ 16600- 16602.5
Colorado Non-competes must be no broader than reasonably necessary to protect the employer’s trade secrets. Non-competes cannot be used for anyone who is not a "highly compensated employee," i.e., an employee earning (both at the time of execution and enforcement) at least $112,500 (as of 2023).  The threshold for highly compensated employees will likely increase over time. 

The employer must give certain notices to the prospective and current employees in order to make the non-compete enforceable. 

Colo. Rev. Stat. § 8-2-113
Florida The non-compete must be reasonable with regard to time and geographical area, and protect a legitimate business interest of the employer (trade secrets, confidential business information, substantial customer relationships, and goodwill to be enforceable; extraordinary or specialized training). Non-competes are more likely to be held as enforceable under Florida law so long as the provisions are drafted to be reasonable in scope and tied to a legitimate business interest.  Fla. Stat. Ann. §§ 542.335
Delaware Delaware courts will not enforce a non-competition agreement that is more restrictive than an employer's legitimate interests justify or that is oppressive to an employee. In a buy/sell context, the non-compete must be tailored to the competitive space reached by the seller and serve the buyer’s legitimate economic interests. The Delaware Court of Chancery recently held that a non-compete entered into in connection with a sale of business was unenforceable due to having a worldwide scope. Non-competition agreements should be drafted to be reasonable in scope, time, and geography to increase likelihood of enforceability.  6 DE Code § 2707
Massachusetts The non-compete must be narrowly tailored to protect legitimate business interest (trade secrets; confidential information; goodwill); limited in time, space, and scope; consonant with public policy. The non-compete must be signed by both parties; provided to the employee 10 business days in advance (or prior to a formal offer, if earlier); state that the employee has the right to consult counsel; and satisfy consideration requirements.  Continued employment is not sufficient consideration to enforce a non-compete. The employee is entitled to certain consideration and notice requirements in order to make the non-compete enforceable. Startups may decide to avoid non-competes with MA employees given the additional cost associated with enforcing these covenants. Mass. Gen. Laws c. 149, § 24L
New York The non-compete must be reasonable in time and space, and no greater than is required for the protection of the legitimate interest of the employer (trade secrets; confidential information; goodwill; employee's unique or extraordinary services). The non-compete must not impose undue hardship on the employee. The non-compete cannot harm the public. A non-compete may not be enforceable if the definition of a competitor is too broad or prevents the employee from working in an entire sector or industry. The non-compete clause should be carefully drafted to meet the requirements under NY law. In New York, there is no state statute or regulation governing non-competes in employment generally.
Texas The non-competition agreement must be reasonable in time, space, and scope, not impose a greater restraint than necessary to protect legitimate business interest (trade secrets; confidential or proprietary information, goodwill, specialized training), and be accompanied by valid consideration.  The non-compete must be supported by valid consideration from the employer to the employee.  Tex. Bus. & Com. Code §§ 15.50-.52

In addition to considering non-compete restrictions on their employees, startup founders should also consider whether they have a non-compete in place with their prior employer and whether there are any concerns with their prior employer enforcing a non-compete against the founder for their participation in the startup. Startups should use caution when asking employees to sign general forms, including Proprietary / Confidential Information and Inventions Assignment Agreement (often referred to as PIIAA or CIIAA), which may contain non-competition clauses that are unenforceable and illegal under the applicable state law.

Stay tuned for updates on the federal rule-making process and how the FTC ultimately comes down on non-competition agreements.