Litigation Over Noncompete Clauses Is Rising

By
• RUTH SIMON
and
• ANGUS LOTEN
• CONNECT

Ramsay de Give for The Wall Street Journal

Rami Essaid, who was sued by his former employer, says noncompete agreements can 'limit your ability to grow and tap your networks.'

More employers are requiring their new workers to sign "noncompete" agreements, which they say are needed to prevent insiders from taking trade secrets, business relationships or customer data to competing firms when they leave.

But with a more than 60% rise over the past decade in the number of departing employees who are getting sued by their former bosses for breaching the agreements, some worry these clauses are having an unintended damping effect on U.S. entrepreneurship, by preventing people from leaving the corporate world to launch their own businesses, or hire workers when they do.

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Take Rami Essaid, for instance. Within a few months of launching an Arlington, Va., startup last year, which protects websites from attacks by automated computer programs, he was sued by his former employer, a large publicly traded computer security firm, saying he had violated a noncompete clause in his previous employment contract. He spent six months negotiating a settlement with his ex-employer. Noncompete agreements, he says, can be a significant impediment to people who aspire to start their own firms because they "limit your ability to grow and tap your networks."

Both large corporations and smaller firms use noncompete agreements. Employers say trade secrets and customer good will can both be put at risk when an employee moves on.

"Employers are always looking to protect their most valuable assets and that includes their workforce, but it also includes things like their trade secrets and their confidential information and customer relationships," says Richard C. Schoenstein, a partner with Satterlee Stephens Burke & Burke LLP. In addition, "a lot of times it's a disincentive to leaving," he adds, noting that employers make a significant investment in employees.

The number of published U.S. court decisions involving noncompete agreements rose 61% since 2002, to 760 cases last year, according to research that the law firm Beck Reed Riden LLP conducted for The Wall Street Journal. Since most cases are settled out of court and most opinions aren't reported, that tally is likely low.

The lawsuits "have a chilling effect," says Matthew Marx, a professor of entrepreneurship at the Massachusetts Institute of Technology. In Michigan, workers were less likely to change jobs and, if they did, were less likely to start their own businesses or jump to a startup or small firm after that state began enforcing noncompete agreements in 1985, he found. Mr. Marx has testified in favor of a Massachusetts bill to limit noncompete clauses; a Massachusetts startup he eventually joined was delayed because of noncompete agreements.

Alan Hyde, a professor at Rutgers University School of Law, says while employers may benefit from enforcing the agreements, there is little evidence of any social or economic advantage: "You have slower growth, fewer startups, fewer patents and the loss of brains to jurisdictions that don't enforce the agreements," he says.

Noncompete agreements are most often signed at the beginning of employment. Once largely aimed at top executives, noncompetes are "reaching wider and deeper within organizations" to include sales representatives, engineers and people involved in research and innovation, says Paul Greco, counsel at the law firm of Buchanan Ingersoll & Rooney.

Agreements were included in 78.7% of 1,000 chief-executive employment contracts at U.S. businesses in 2010, compared with 72.5% in 2000, according to a study released in February and conducted by researchers at the University of Michigan, New Mexico State University and Vanderbilt University.

Startups, which tend to have less financial flexibility than bigger firms, say noncompete agreements can throw a wrench into the recruiting process. Jon Hirschtick, the founder of Belmont Technology Inc. in Cambridge, Mass., says noncompete agreements have made it tougher for his nine-month-old startup, which makes product-design software, to recruit software engineers. "We've had inquiries from many people we'd otherwise like to hire, that we cannot because of their noncompete agreements," he says.

Even so, he also requires new employees to sign noncompetes "as a way of protecting some of the value we create."

Jacqueline Thong says a noncompete agreement prevented her from hiring a business-development expert in the emerging digital-health market, for her two-year-old Boston-based startup, Ubiqi Health: "There's not a lot of people in the digital-health field, so if you want someone who comes from our industry it's a real challenge," she says. "We're not in a position to litigate."

James Keating, chief executive of the Keating Group, a commercial insurance broker, says his firm at times has shied away from recruiting executives with noncompete agreements because of the potential cost of litigation and the expense of paying an employee until such an agreement expires. "We're around $8 million in revenue," he says. "I'm confident we would be double our size if we didn't have that to deal with."

In certain states, such as Florida and Massachusetts, it is relatively easy for a business to enforce a noncompete agreement, if an ex-employee started or joined a rival business within one year of his or her departure. But as concerns about economic development grow, some states now are looking at ways to limit the reach of these agreements.

In July 2012, New Hampshire enacted a law that voids noncompete agreements that aren't provided to applicants before or when a job offer is made, or when a current worker's position changes. Massachusetts will hold hearings in early September on a bill that would generally limit such agreements to six months. State legislators in New Jersey and Minnesota have also recently introduced bills to limit or void these agreements.

California, where startups are plentiful, makes it particularly difficult to enforce such agreements. There, most noncompete agreements are considered void under California Business and Professions Code, and as a result, it is fairly common to find founders who left nascent California companies building a rival.

Noncompetes are one reason there are "virtually no spinoffs" from large Massachusetts-based technology companies, says Gwill York, a managing director with Lighthouse Capital Partners, which provides venture financing and has offices in Cambridge, Mass., and Menlo Park, Calif. Some students she mentors feel they have to go to California if they want to join a startup "because they will have mobility," she adds. "Here if they stay and join a startup they may not be able to switch jobs and stay in their field of expertise."

"There's no question that we've passed on startups because of restrictions these people didn't know they've had and we have seen startups we work with unable to hire people because of restrictions potential employees have," says Bijan Sabet, general partner at Spark Capital, an early stage venture-capital firm based in Boston. "We've also seen people leave the state" because of how noncompete agreements are enforced. Spark Capital doesn't require management or employees of the companies in which it invests to sign noncompete agreements, he adds.

A 2011 study by Olav Sorenson, a management professor at Yale University, found that the enforcement of noncompete agreements appeared to impede innovation, with nearly all the effects of venture capital on the formation of startups and job growth coming in states that didn't enforce these agreements. In an earlier study, he found that biotech spinoffs were common in states that didn't enforce noncompete agreements, but rare in those that did.

Even in states that don't enforce noncompete agreements, employees can face lawsuits alleging that they have misappropriated trade secrets, says Russell Beck, a partner at Beck Reed who drafted the proposed Massachusetts legislation. Employers are less likely to bring trade-secrets lawsuits because these cases are more costly, often requiring depositions and more extensive discovery. But defending against them is likely to be "more expensive and will have a greater impact on the employee and startup company," he says.

Noncompete agreements can offer employers more protection than trade-secrets laws because "there's a bright-line test," says Mr. Beck. "The problem with relying on trade-secrets law is that it's very hard to discover whether somebody has used your trade secrets." New employers can sometimes limit the impact of noncompete agreements by restricting "the employee to a more narrow role than what had been planned," Mr. Beck adds.

Ann Anderson, who started Nexus Staffing Specialists in Larchmont, N.Y., last year, opted to wait one year to begin building a business filling temporary positions for clients, in order to avoid a potential lawsuit by the company two former employees had worked for. "That had a significant impact on our growth over the last year," she says. "But I thought it was a better choice as a startup."

Mr. Essaid, whose company raised $2.1 million in funding last year and now has 15 employees, says recruiting has been difficult, since he met most of his industry contacts in his former job. "You become gun shy and don't want to be seen as poaching their talent," he said. "It's really limiting our pool of options."

Write to Ruth Simon at ruth.simon@wsj.com and Angus Loten at angus.loten@wsj.com

A version of this article appeared August 15, 2013, on page B1 in the U.S. edition of The Wall Street Journal, with the headline: When a New Job Leads to a Lawsuit.