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.
|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.