Do you require employees to sign a restrictive covenant?

Ask any buyer of a pest control firm what asset garners the most value yielding the highest price and the reply will be customer relationships, the profitability of those relationships and the likely retention of these relationships upon sale. Some of the best PCO firms that we know have routes that have technicians with longevity who are many times treated by the customer like a great friend or even family.  While this is a great way to build a business, what protects you as the owner from a technician who blurs the line of customer ownership and decides to leave and take the customers that he services with him? Having employees sign a restrictive covenant or non-compete is one way to make it more difficult for an employee to steal customers.

If you are looking to sell your business, one of the first questions a potential buyer will want to see is how your non-compete is written so as to help ensure high customer retention after the sale. Your customer list is your most valuable asset. The idea is to protect it and not have an ex-employee become your worst nightmare. This is a real risk and one that will most assuredly occur absent implementing appropriate legal safeguards.

The prudent business owner will develop an agreement with standard language that incorporates the employee’s agreement to abide by one or more restrictive covenants whereby an employee who breaches such covenants may end up getting sued from the ex-employee seeking money damages and/or an injunction imposed by a court declaring that the ex-employee inappropriately solicited customers.

Restrictive Covenant: Are there rules?

Unfortunately for employers, most states frown upon such restrictions being imposed on an employee who has a basic fundamental human right to earn a living. Consequently, the courts generally will favor an employee unless the employer is able to establish that the employee has illegally misappropriated employer trade secrets and/or used specialized training techniques in its efforts to steal the ex-employer’s business.

This becomes the competing interest and the “employee’s right to work” vs. “an employer’s right to protect legitimate business interests” vs. a “customer’s right to choose who they hire” is the basic overall framework in which each situation is evaluated.

The difficulty in applying such analysis gets complicated when adding basic contract law principles in which every contract must have consideration exchanged between the two parties to an agreement. If an employee promises the employer something (e.g., not to compete or solicit) then this is considered given on the part of the employee – but what did the employer give in exchange for the employee giving up a valuable right? Court cases throughout the USA have deliberated on whether the mere giving a job is sufficient consideration given in exchange to make the restrictive covenants valid.

What if the employer gave the employee a discrete bonus for $1, $10, $100, $1,000 extra as specific consideration in addition to giving a job—is this sufficient consideration or is the amount to insignificant to even count?

To make matters more difficult, what is a “trade secret” deemed worthy of protection under the law? Does specific knowledge about a customer in terms of the type of services the customer receives year after year a trade secret? No one glove fits all sizes and therefore the facts of each situation and how the restrictive covenant was written will also be thrown into the pot in determining whether the employer gets court relief or not. So what is the business owner to do?

The answer lies in two parts to the contract: (i) Contingent Severance; and (ii) Liquidated Damages.

Contingent Severance

Most employers don’t like the recommendation to pay the new hire employee an extra fee to compensate the employee for giving up the valuable rights set forth in the restrictive covenants. Even if amenable, what is the right amount that a court will not view as insignificant and therefore be tossed out as a nullity? There is no answer to this, therefore, it may be better not to guess and simply provide in the employee’s employment agreement/offer letter a provision that states the employer can, at its election, impose a restrictive covenant for a period of time that is a range of months/years and corresponding dollar amount the employer will elect to pay at the time the employee is terminated. If an employee is in a position that he would not be able to do harm, no payment would be made at his departure. Therefore you can pick and choose who to restrict upon exit.

For example, an employer can create the optional severance schedule depending on how long the restriction will be imposed. This assures the consideration (if ever paid) is not immaterial and allows the employer to defer a decision about payment instead of guessing what to do up front and without knowing whether the new hire will turn out to be a future threat. If the employer chooses not to enforce the covenant (and pay the severance) then the employee is free to go unencumbered and of course no severance either. It is the ultimate flexibility for an employer.

Liquidated Damages

Another way to avoid legal fees to try and enforce the non-compete and prove the damages sustained by the breach of the ex-employee, is to simply add a clause that says any breach of the covenant will have a set formula dollar value so that if a customer is taken by the ex-employee then the clause would simply say that the agreed damages are 2 or 3x the dollar value of the lost revenues for such customer measured in the 12 months prior to losing the client. What this does is short-circuit all the factual issues discussed earlier in the article about whether the restrictive covenant is even enforceable or not. This is simple and a straight breach of contract action as if the employer sold a customer account to the ex-employee for a stated price.

This is very difficult for an employee to overcome because if the ex-employee ends ended up with the customer then it is no longer about trying to prove illegal competition at all. This approach is a huge deterrent to an employee who is thinking of taking the customers for free as they will come to realize they can take the customers but he will now be purchasing the customer for an agreed upon price to the ex-employee who is now essentially a selling party.

By John P. Corrigan, Esq., CPA, MBA