Non-Competes: More Carrot, Less Stick
The impending need to create post-employment loyalty incentives
Non-competes have become ubiquitous. Once reserved for key engineering talent and senior executives, and largely restricted to the Tech and Finance industries, covenants not to compete – or “non-competes” -- have spread to the farthest reaches of the economy. These days, it’s not unheard of for a fast-food restaurant to deploy a non-compete to ban a minimum-wage worker from taking his burger-flipping skills down the street.
For example, Jimmy John's, a national sandwich chain, required its employees to sign a non-compete banning them from working at any fast-food restaurant within a 3-mile radius of any Jimmy John’s restaurant for two years after leaving the company. Valvoline, the oil-change franchise, required its employees to sign a non-compete prohibiting them from working in the oil change business at any facility within a 100-mile radius for one year after leaving Valvoline. And Amazon required its warehouse workers (including temporary, seasonal workers) to sign a non-compete that restricted them from working for any competitor that directly or indirectly engages in or supports any business that competes with Amazon, for 18 months after leaving the company. (This scope includes any company that sells any goods or services that Amazon also sells, thus effectively barring all jobs in retail).
Non-competes under attack
In response to this kind of excessive and abusive use of non-competes, a growing list of states have either restricted them or banned them outright, including California, Colorado, Illinois, Maine, Maryland, Massachusetts, Minnesota, Nevada, North Dakota, Oklahoma, Oregon, Rhode Island, Virginia, Washington and the District of Columbia. More states are likely to follow.
The California statute is particularly instructive, both because California tends to be a trendsetter in legal matters, and also because many of MSP’s clients are either California companies or do extensive business in California. Non-competes have generally been unenforceable in California since 1872, but in 2023, California passed a law which aggressively extends the reach of its pro-competitive policy. Specifically, the new law applies to both (a) contracts entered into outside of California and (b) employment by non-California employers, as long as the employee is a California resident. Assume that a Boston-based company enters into a non-compete with a developer who lives in Massachusetts, under a contract that is expressly subject to Massachusetts law. If that developer moves to California to work for another company, the Massachusetts employer will be unable to enforce the non-compete. Furthermore, even if the developer, having moved to California, ends up working remotely for another Massachusetts company, the non-compete will still be unenforceable.
Minnesota, North Dakota and Oklahoma also ban non-competes, albeit without the extra-territorial effects of California law. Most other states do not ban non-competes outright, but instead focus on limiting their scope, generally along one or more of the following dimensions:
Duration
Geography
Seniority of employee
Whether the employee is compensated for the non-compete
As a representative example, Massachusetts passed major non-competition reform in 2018. The Massachusetts statute bars non-competes for non-exempt employees, and limits non-competes for other employees to one year in duration. Most importantly, all non-competes must be supported by “mutually agreed upon consideration”. While the statute does not fully specify what types of compensation satisfy this standard -- and this is currently the subject of active litigation in the state – the statute does specify that a garden leave qualifies as adequate consideration, assuming that the employee is paid at least 50% of their base salary throughout the garden leave. (See the discussion below on garden leaves more generally).
More recently, the federal government has gotten into the act. On April 23, 2024, the Federal Trade Commission promulgated a new rule (the “FTC Rule”), effective September 4, 2024, that would have banned all non-competes going forward, and voided all existing non-competes except those binding “senior executives”. The FTC Rule was promptly challenged in multiple jurisdictions, but the case that moved the most quickly was filed in the Northern District of Texas, and on August 20 Judge Ada Brown vacated the FTC Rule, not only with respect to the plaintiffs in that case, but nationwide. While other courts have upheld the FTC Rule in preliminary proceedings, Judge Brown’s ruling will remain the law of the land unless it is overturned on appeal. And even if the FTC brings an appeal, it will likely take 2-3 years to wend its way through the courts – so at least for now, the FTC Rule is a dead letter.
While it may be less relevant to many of MSP’s clients, the National Labor Relations Board (NLRB) has recently stepped up both its guidance and enforcement with respect to non-competes.
In addition to this regulatory activity by federal agencies, there are multiple bills working their way through Congress that would restrict or ban non-competes.
And finally, while it’s beyond the scope of this article, it appears that the trend internationally is also towards heightened scrutiny of non-competes.
Mindset shift: from sticks to carrots
Given these shifting sands of public policy, what’s a forward-looking CEO to do?
Our view is that the ready availability of non-competes has fostered an ongoing failure of imagination, and that a radical re-think is in order. Consider the following thought experiment: The nearly universal rule in the US labor market is that employment is at-will, at least from the employee’s perspective. An employee can leave his job at any time, for any reason. Now, imagine a parallel universe in which employers could force employees to enter into binding covenants to not leave their employment. (The legal term of art for such a covenant is “indentured servitude”). In such a parallel universe, employers would have no reason to develop the rich menu of employee-satisfaction and employee-retention strategies that are now commonplace, e.g.: Stock grants, deferred compensation, pensions, parental leave, etc., etc. Why bother with such niceties, when you have the crutch of indentured servitude to fall back upon?
In our current universe, thankfully, no such crutch is available. In the absence of a coercive legal mechanism (a “stick”) to enforce employee retention, companies have become remarkably creative in developing market-based mechanisms (“carrots”) to encourage employee loyalty, during the period of employment. But because there is a crutch available to enforce employee loyalty post-employment – the non-compete – companies have done far less to develop market mechanisms to address this scenario. Given the trend towards non-competes being disfavored and/or disallowed, this failure of imagination needs to change.
So how might an innovative employer go about encouraging post-employment loyalty?
Don’t waste your sticks
The first thing to understand is that there are already strong statutory protections in place for most “coarse grained” forms of intellectual property, such as the trade-secret formula for Coke, the patented formula for Lipitor, or Nike’s trademarked Swoosh. The purpose of non-competes is not really to provide redundant protection for these coarse-grained forms of IP; rather, non-competes – and the less coercive alternatives to non-competes discussed in this article – are intended to protect the finer-grained IP (essentially know-how) that arises from exposure to all of the day-to-day details of working for a given company. So if you’re trying to protect coarse-grained IP, don’t waste your efforts with a non-compete that will be redundant at best, and non-enforceable at worst.
Replace sticks with carrots
Perhaps the most direct and obvious idea is to replace the penalties attached to competition with a reward for not competing. This is basically the goal of garden leaves. Initially developed in the Finance industry, garden leaves basically re-conceptualize the period of non-competition as an extension of the employee’s term of employment ... albeit one in which the employee has no responsibilities other than not working for a competitor. Essentially, a company pays a departing employee to “sit on the bench” for some period of time, during which they are prohibited from working for a competitor.
What makes garden leaves so powerful is that the competitive threat posed by most employees has a relatively short half-life: If you leave Company A on a Friday, and start work at Company B on Monday, what you know about Company A could be quite valuable to Company B. If, however, you’ve spent the last 6 months puttering about in your garden, you’re much less likely to pose a proprietary threat to Company A.
Garden leaves are most common in Finance, where having spent at least some time “gardening” is a bit of a status symbol, as it denotes that your skills are in high demand. For example, Giuseppe Paleologo is a highly sought-after Quant who has worked at Citadel (twice), Millennium, and Hudson River. Since 2017, he has spent over 30 months(!) on garden leave, as various firms poach him from one another.
Garden leaves are starting to become more common in Tech as well, although the labor market dynamics differ a bit from those of Finance. In particular, garden leaves in Tech tend to be considerably shorter than in Finance, as the decay rate tends to be much faster for both:
The IP of the firm enforcing the garden leave
The skillset of the employee subject to the leave
This means that, at least in theory, garden leaves should be a more cost-effective tool in Tech than in Finance, as a shorter, cheaper and more enforceable intervention in the former case may be just as effective as a longer intervention in the latter case.
Dangle the carrot at the end of a long stick
Another promising approach is to re-deploy some of the same carrots that employers currently use to promote loyalty amongst current employees, and time-shift them to encourage loyalty amongst ex-employees. Deferred compensation is the most obvious example of this strategy, and one of the most successful examples of deferred compensation is Renaissance Technologies.
Renaissance Technologies (“RenTech”) is widely regarded as the best-performing investment firm of all time. Its flagship Medallion Fund boasts an average annual gross return of 68% over 34 years, without ever experiencing a loss. While RenTech reportedly requires its employees to sign non-competes, it is limited by the scope restrictions on non-competes under New York law (currently limited to ~2 years, with this number likely shrinking). And RenTech is in a corner of Finance (hedge funds & proprietary trading) where firms are constantly poaching each other’s talent. And yet, it is exceedingly rare for a RenTech employee to ever leave the firm: The average tenure of its employees is nearly 15 years, and the vast majority of RenTech employees simply retire from RenTech. Even amongst those employees who leave RenTech to join a competitor, there seems to be remarkably little leakage of RenTech’s proprietary methodology. One reason may be the way that RenTech compensates its employees and alumni.
Medallion has a distinctive fee structure: Whereas most of its peers use a 2+20 model (2% management fee, applied to total AUM, and 20% carry, applied to all profits above a given threshold), Medallion’s fees are 5+44(!). But what’s bizarre is that Medallion doesn’t have any outside investors – all of the LPs are senior RenTech employees. At first blush, it might appear that RenTech is just robbing Peter to pay Paul, but on closer consideration this very aggressive fee structure serves as a kind of inter-generational wealth transfer: In effect, older RenTech employees (who have most of their wealth tied up in LP interests) are paying younger RenTech employees to work for them, via hefty GP fees that accrue to the entire firm. Then, over time, the younger employees are gradually given LP interests themselves, as a powerful retention mechanism.
The critical feature of the LP interests in Medallion is that they provide a stream of future returns, with no practical way to capture the NPV of that stream. This distinguishes them from the stock packages typically offered by high-growth Tech companies. Those equity grants are intended to align the interests of the employee with those of the shareholders, and in the early days of Tech, they did a reasonable job of this ... at least until a company went public. But in the modern era, there is such a robust secondary market that employees (and especially ex-employees) can easily liquidate most or all of their holdings over a relatively short time horizon. So, whereas a RenTech LP is well aligned with RenTech for the rest of their life, the average Tech employee (or ex-employee) can reduce their exposure to the employer in a relatively short amount of time. Tech companies that wish to minimize adversarial behavior by ex-employees should explore creative compensation packages that maintain the ex-employee’s alignment for the long term.
Grow new carrots in collaboration with your ex-employees
Another strategy for fostering loyalty amongst ex-employees is to treat your alumni as just another facet of your company’s broader ecosystem, just as you would a corporate partner in a joint venture or a marketing alliance.
Andrew Bialecki and Ed Hallen, the co-founders of Klaviyo, offer seed investments of $25K-$50K to certain employees who leave Klaviyo to found their own businesses. This specific tactic will not be available to every company: It is dependent upon Klaviyo’s founders being sufficiently wealthy – and having sufficient appetite – to make speculative venture investments, as these same investments might be considered a breach of duty to Klaviyo’s shareholders, were they made by the corporation itself. The broader point is that Bialecki and Hallen are sensitive to the imperative to promote alignment among all corporate constituencies – not just current employees, but also ex-employees – and they have come up with a creative, win/win alternative to the threat-based regime of non-competes.
Conclusion
Fostering genuine loyalty amongst former employees requires a lot more creativity than punishing disloyalty via the blunt instrument of non-competes. But it’s the same kind of creativity that companies already devote to fostering loyalty amongst current employees, which itself curtails employee migration to competitors in the first place. And as non-competes and other coercive methods become increasingly disfavored in many jurisdictions, companies with happy, well-aligned employees and alumni will enjoy a distinct competitive advantage.
When all you’ve ever used is a stick, a little bit of carrot goes a long way.
By Jonathan Bain, Partner