FTC’s proposed non-competes ban raises doubts for start-ups’ dealmaking 

A proposed rule by the Federal Trade Commission that would ban employers from imposing non-compete agreements on their workers, if passed, is likely to upend the way in which M&A deals involving venture- and private equity-backed tech companies are negotiated, say lawyers and advisers who facilitate these deals.

Arguing that “the freedom to change jobs is core to economic liberty and to a competitive, thriving economy,” the FTC has said putting an end to non-compete agreements “would promote greater dynamism, innovation and healthy competition.” It estimates the rule could increase wages by nearly $300 billion per year and expand career opportunities for roughly 30 million workers.

If non-compete clauses are no longer permitted in employee contracts, companies seeking to be acquired will have to introduce alternatives to give buyers comfort that their employees won’t share trade secrets or other proprietary information with their competitors. As it stands now, a buyer of a VC-backed company typically insists that the key employees of that company agree to not to compete with the buyer for three to five years upon leaving the company.

“Investment firms are going to have to figure out whether there are alternative types of restrictions that provide them the comfort that they need to get a return on their investment or to make the investment in the first place, in the absence of a non-compete,” Kevin Passerini, a partner in Blank Rome’s trade secrets and competitive hiring practice, told Venture Capital Journal.

“If you’re investing in a start-up business that’s either tech-driven or engineering-driven in terms of developing a product, there are people at that business who either don’t hold equity or who likely own a very small amount that would be very damaging if they left,” Passerini said. That would put a greater focus on retention benefits to try to keep employees from leaving, he noted.

It’s noteworthy that because non-compete clauses are already prohibited under California law, the FTC rule would be moot in Silicon Valley.

As currently written, the proposed ban applies only to non-compete provisions for employees who hold less than 25 percent of the equity in their company at the time they agree to the provision and are selling all, or substantially all, of their equity to the buyer.

Passerini said he’s optimistic that the FTC’s final rule will look similar but “will have a lower percentage threshold for equity ownership” in order to qualify for the non-compete exception. “They’ve signaled they’re open to anything between 10 and 50 percent,” he said. “Obviously, 50 percent would be outrageous because very few partners or worker-equity holders would ever be subject to a non-compete if that were the threshold,” given the dilution that occurs with multiple funding rounds.

The scope of the exception to the proposed ban on non-competes does not include covenants that workers are sometimes required to agree to in exchange for an investment that a VC or PE firm makes in their company, said Passerini. Those covenants are outside the context of a total sale of equity or assets by an employee.

It’s fairly clear, however, that the ban would also apply to redemption-type agreements that include a non-compete provision in exchange for permission to dispose of all of a person’s assets. For example, if “somebody either ceases being a member of a [limited liability corporation] or is forced to give up their stake when they end their employment” in an LLC, the rule would still apply for anyone who doesn’t meet the 25 percent equity ownership threshold, Passerini noted.

Moving provisions to M&A pacts

If the FTC succeeds in banning non-compete agreements, provisions for non-solicitation agreements and the return of property, which historically have been part of individual employment agreements, will likely be incorporated into M&A agreements and used to indemnify buyers for any losses tied to improper conduct by any of the target company’s employees, said Michelle Kirkpatrick, who heads the shareholder advisory practice at SRS Acquiom, which represents former security holders of target companies after acquisitions close.

Kirkpatrick notes that the FTC rule doesn’t touch non-solicitation agreements, which prevent an employee from telling co-workers or clients that they’re joining a new company and encouraging them to leave their old company. Return-of-property provisions require that every customer list, text message, computer and possibly even cellphone be returned to the company when an employee leaves.

Once such provisions are integrated into a merger and acquisition agreement, “if the buyer learns that the sellers in leaving the company have taken any property, taken any customer lists, taken their computer, the sellers are collectively responsible for indemnifying the buyer for that individual’s conduct,” said Kirkpatrick. “This is one way buyers can achieve what they otherwise would have lost or at least approximate what they otherwise would have had under the old traditional regime where they could lock these folks up in a non-compete.”

The proposed rule also includes language about de-facto non-compete clauses, which buyers would need to be mindful of, said Kip Wallen, senior director and head of thought leadership at SRS Acquiom. That could include customer non-solicitation provisions that prohibit former employees from selling to the customers they sold to previously.

“If you’re in a niche market for dental devices where there’s only a limited number of customers, and you can’t sell dental devices to any of the customers to whom you sold [them] previously,” then you can’t really work, Kirkpatrick noted.

Even while the FTC rule remains in the proposal stage, it’s likely to expand the scope of buyers’ due diligence processes to include a broader set of employee non-compete agreements that a target company has in place, said Wallen.

In the past, buyers would have wanted to examine employment agreements for a target firm’s 20 key employees. Now they’re more likely to ask to see agreements for all employees, Wallen said. “In the proposed rule, you have a certain window of time to rescind a former non-compete agreement for a founder, for instance, so buyers need to start thinking about that.”

Shift in employment contracts?

Because the FTC’s proposed rule would have no impact on during-employment restrictions, firms that are closing a funding round or a sale may want to ensure they “have really strong and enforceable non-solicits or confidentiality provisions and consider making people term employees as opposed to at-will employees,” said Passerini.

There are disadvantages to that, such as having to retain workers for an extended time period unless there is cause to terminate employment, he noted. The benefit, however, is “those agreements are likely to remain enforceable, and individuals who are subject to term agreements are not as easily hired or poached by competitors, which is valuable. And to the extent they’re employed, they’re going to owe during-employment non-compete obligations similar to the duty of loyalty.”

Such a shift might also require extended notice provisions for how far in advance employees must state they plan to resign, as well as multiple retention features to keep them engaged, Passerini added.

Many VC managers would be likely to embrace a ban on non-compete clauses and elimination of the threat of non-compete litigation, said Kirkpatrick. In a labor market where so many employees are bound by these provisions, it will be very hard for start-ups to acquire the talent they need to develop.

Getting hit with a lawsuit for breach of a non-compete can sink a start-up that doesn’t have much cash before it gets off the ground, she said. “For some VCs investing in these start-up companies, the access to talent without the threat of litigation can be really meaningful and probably really exciting.”

The FTC’s proposed rule has sparked some opposition, including from the US Chamber of Commerce. Much of it centers on the fact that the rule would apply retroactively to all deals done previously whose restrictions remain in effect, Passerini said.

Most people in business “are more comfortable if there’s a rule that would be applied going forward because then they can value deals and make investment decisions based upon knowledge that they’re not going to have certain protections [in the future],” he noted.

The public comment period is scheduled to run until April 19. (Comments may be made on the FTC website here.) Many groups have asked that the deadline be extended. While that’s unlikely, the FTC could revise the rule and offer a new public comment period. It’s also possible that the commission would revise it without offering another comment period.

Passerini said he doesn’t believe the FTC has the authority to ban non-competes because it lacks legislative authority, can’t create its own laws and has to operate within the confines of whatever the US Congress has passed.

“I would expect it to be enjoined pretty early out of the gate, and there’s been plenty of threats from the US Chamber and many other advocacy groups,” he said. “I think there’s some grumbling that the state attorney generals may go after this as well. If those sorts of lawsuits materialize quickly, which we expect, this could be put on ice very quickly.”

The eighth and ninth paragraphs have been updated to reflect a corrected percentage range and wording, respectively.