Non-Compete Covenants In Crowdfunding And Fintech

Co-Authored By: Adam Gersh & Mark Roderick

Taking a break from securities laws, we’ll take a look at using non-compete covenants in the Crowdfunding and Fintech world.

By “non-compete agreement,” we mean a contract that prohibits an employee from being employed by, or engaging in, a competitive business after she leaves.

EXAMPLE:  Real estate Crowdfunding company ABC requires its non-clerical employees to sign an agreement promising not to work for any other real estate Crowdfunding business for two years after termination of employment.

To be clear, when we say “non-compete agreement” in this post we don’t mean (1) a confidentiality agreement (a contract that prohibits the employee or contractor from using trade secrets or other confidential information), or (2) a non-solicitation agreement (a contract that prohibits the employee or contractor from soliciting customers or employees after she leaves). Confidentiality agreements and non-solicitation agreements are often used in conjunction with non-compete agreements but generally don’t raise the same legal and ethical questions.

Are Non-Compete Agreements Ethical?

Over the last year, I’ve seen a lot of press arguing that non-compete agreements are unethical — a form of human bondage. It’s more complicated, in my opinion.

When the U.S. economy was based on manufacturing, no one thought it was okay for an employee to haul away his employer’s tools when he quit. In today’s knowledge-based economy, where a $65 billion taxi company called Uber owns no taxis, the assets of most companies are intangible, i.e., knowledge and information. If employees can haul away those assets when they leave, there’s a problem.

Most of the time, employers are trying to protect two things:  confidential information and contacts/relationships. If confidentiality agreements and non-solicitation agreements were easy to prove and enforce, we probably wouldn’t need non-compete agreements. The problem is that they’re very difficult to enforce because violations are very difficult to prove – did the former employee solicit the customer, or did the customer solicit her? So, companies use non-compete agreements as a sort of “backstop.”

Here are a few hypotheticals that illustrate the ethical dilemma:

  • Real estate Crowdfunding company ABC hires Jean Smith, who knows nothing about real estate or Crowdfunding. After three years she leaves and starts her own real estate Crowdfunding company, competing with ABC for deals and investors based on the relationships and reputation she developed while on ABC’s payroll.
  • The same facts as above except Jean was fired for embezzlement.
  • The same facts as above except Jean was laid off because her job was replaced by an algorithm.
  • The same facts as above except Jean brought her own personal contacts to ABC as investors.

Are Restrictive Covenants Enforceable?

I can’t count the number of times I’ve been asked “Non-competes aren’t enforceable, right?”

In general, that’s wrong. Properly-drafted non-compete agreements are as enforceable as any other contract in most American jurisdictions. The giant exception to that rule is California, where non-competes for employees are per se unenforceable (with limited exceptions).

Almost everywhere else, a non-compete agreement is enforceable as long as the agreement is “reasonable” to enforce the legitimate interests of the employer. Whether a given non-compete agreement is “reasonable” depends on lots of factors, including the duties of the employee in question (e.g., business development vs. clerical duties), the duration of the restriction, and the geographical limitation. Despite their name, non-compete agreements can’t be used to prohibit competition per se. They can be used only to prohibit competition that is unfair based on the facts and circumstances.

The geographical limitation in particular creates hard questions in Crowdfunding and Fintech, where many businesses are either national or international in scope.

EXAMPLE:  A dental practice in Chicago attracts 80% of its patients from a seven mile radius. It would be unreasonable for the practice to prohibit its employees from working in Texas. But a real estate Crowdfunding business in Chicago, with projects from California to Texas to New York, is a different story. Can that business prohibit its employees from working anywhere?

Then there’s the question of what the company’s business really is. Is it a general dentistry practice or a specialist orthodontic practice? Does the company do all kinds of real estate Crowdfunding or only residential fix-and-flips? With about eight and a half million accredited investors in the U.S. alone, but only a small fraction having signed up at Crowdfunding sites, are Crowdfunding companies – real estate or otherwise – even competing with one another in the traditional sense?

Things are even more complicated in the blockchain world. Are all companies issuing tokens competitors? No. But two companies issuing tokens based on distributed digital storage are probably competitors, even if one is based on New York and the other in Silicon Valley.

Do Non-Compete Agreements Apply Only to Employees?

No, non-compete agreements can be used for contractors and vendors as well as for employees.

Do Non-Compete Agreements Inhibit Innovation and Economic Growth?

We’ll leave that to the economists.

Are Non-Compete Agreements Effective?

In general, yes, they are very effective. Meaning:  an employee who is subject to non-compete agreements generally doesn’t compete.

For one thing, the employee generally wants to comply with her contract, even if the contract seems a little overbearing and a lawyer says it might not be enforceable. So she chooses a new job that doesn’t violate the non-compete agreement, if she can.

But most important, a company that hires an employee subject to a non-compete agreement can also be liable. Once it learns about the non-compete, the new employer usually withdraws its offer, effectively “enforcing” the non-compete on behalf of the former employer and forcing the employee to look for a job elsewhere. Every now and then a new employer wants the employee so much that it takes the risk, but very seldom.

Recommendations

If you’re a company and aren’t located in California, you should have your employees sign non-compete agreements, period. Think about what you’re trying to protect and draft the agreements accordingly.

If you’re an employee think hard before you sign one. It’s probably enforceable, and it might affect your ability to find another job if you leave.

Form of Agreement

Here is a form of an Invention, Non-Disclosure, And Non-Competition Agreement. In addition to a non-compete agreement, this contract includes a confidentiality agreement, a non-solicitation agreement, and a provision that makes the company the owner of any inventions of the employee, useful in most tech companies.

CAUTIONS:

  • Don’t assume this agreement will be right for your company or that it will be enforced as written in your state.
  • This contract was written for a real estate Crowdfunding portal. It can be modified for other Crowdfunding or Fintech companies.

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