Tax & Business Insights

Covenants Not to Compete – Don’t Wait

Volume 17 Issue 6 -- November/December 2005

Melvin Muddle (“Mel”) started Muddle Mud, Inc., in 1973 after discovering that mud packs made from the mud found in Muddleburg produced extremely beneficial results. Muddle Mud was good for the complexion, coughs, colds and sore muscles. Fortunately for Mel no other area had the same type of mud as Muddleburg.

When Mel started the company he was smart enough to realize that it would attract a talented group of well paying clients and that he should limit the application to that group through excessive pricing. In 1997 Mel read an issue of Tax & Business Insights called "The Lost List or Technology Taken" which discussed the importance of protecting intangible business assets. Mel however decided that the warnings therein probably didn’t apply to him because his business was well run and no employee had ever quit.

That belief was probably true until 1998 when Mel hired a young business graduate named Sally Cunning (“Sal”). Sal had a degree in business marketing and was quite capable of obtaining and servicing clientele for Muddle Mud. As time went by, Sal came to know and deal with all of Mel’s best customers.

As luck would have it, as a result of a meteor striking near Muddleburg in 2005 another lode of the magic Muddleburg mud was discovered. Cashing in on this discovery, Sal launched her own mud company.

Since Mel had ignored the need for a Covenant Not to Compete with Sal when he hired her in 1998, she was able to leave his employ and compete quite effectively. In fact, her mud was even more beneficial than the original Muddle Mud. Reportedly, it also cured smoking and alcohol addictions. Since Sal was familiar with all of Mel’s customers, it was easy for her to contact them and compete with Mel’s business.

The Expected

Upon learning of Sal’s imminent departure in 2005, Mel insisted that Sal sign a Covenant Not to Compete. As one might expect, after working for Muddle Mud for seven years Sal refused to heed Mel’s entreaties about the need for a Covenant Not to Compete and she refused to sign. Even if she had signed, the Covenant might not be effective. Accordingly, Sal was able to compete without any restrictions with regard to the clientele of Muddle Mud.

The message is, if you hope to prevent an employee from competing with you now or later, it is essential that you have a binding contractual agreement called a "Covenant Not to Compete." Usually, it must be signed when the employee begins work. Some states have sharp limits on an employer’s ability to prevent former employees from competing.

A Covenant Not to Compete is a promise in writing that the employee will not compete for a reasonable period of time within a limited geographical area. The Covenant can also be designed to prevent the employee from soliciting the existing clients of a business. Covenants can also be coupled with agreements designed to prevent former employees from using trade secrets or confidential information.

It is essential that a Covenant not be overly broad. For example, a Covenant requiring that a departing employee refrain from competing anywhere in the world for the remainder of his or her life would not be enforceable. Such a restriction might mean that the person could never work again, and courts would likely rule it to be unreasonable and thus unenforceable.

Surprisingly, small and large businesses often ignore the need to safeguard customer lists and confidential information. If an employee works for a business for any period of time he or she will undoubtedly get to know the clients or customers. If there are no restrictions preventing departing employees from soliciting customers or competing, an ex-employee can begin competing as soon as the employment terminates. In such cases, employers like Muddle Mud have no way to prevent a former employee like Sal from soliciting their existing clients.

While there is no way of preventing an employee from leaving and eventually competing after the restrictive period for competition has expired, the existence of the Covenant at least gives the departing business a chance to monitor its client structure and make effective moves to keep them using Muddle Mud.

Even if you don’t have a great product like Muddle Mud, you may have clients who are worth keeping, in which case it would be a good idea to consider having an agreement with all new employees that they will not solicit the existing client base should they leave.

If you need assistance with regard to these issues, call The Tax and Business Professionals, Inc.

While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.

Redistribution or other commercial use of the material contained in Tax & Business Insights is expressly prohibited without the written permission of Tax and Business Professionals, Inc.

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