Finding the Right Equilibrium for Effective Non-Compete Agreements

When states permit policies that shackle labor mobility, without consideration for the economic costs such enforcement imposes, both prospective entrepreneurs and the economy as a whole suffer. One example of how state policy can impact labor mobility is through non-compete agreements. 

In previous posts, I emphasize that well-functioning labor markets are essential pieces of growing economies. When people can move in and out of different industries, between employment and entrepreneurship, and between locations, they can best find where their skills are the most valuable. 

The mismatch of talent to job openings, or a worker’s inability to find a better match, can have a significant effect on unemployment and productivity. This is especially true for younger workers. Here, I explain the consequences of improperly enforced non-compete agreements and its impact on entrepreneurship and growth.

Non-compete agreements have become an increasingly common legal obstacle to labor mobility. In my opinion, restricting exiting employees, who are potential direct competitors, from using trade secrets or customer lists is a fair use of non-compete agreements. This application is why nine out of ten managers or technical employees report that they are bound by non-compete agreements. 

But individuals with very specialized skills can feel how painful non-competes can be. When these individuals aren’t able to break out on their own and test their ideas as an entrepreneur, potential growth opportunities are wasted.

And the presence of non-competes is not just prohibiting entrepreneurs from moving from employment to entrepreneurship. It also shrinks the pool of available talent that entrepreneurs need to jumpstart their companies. When new firms need workers with technical knowledge to innovate or iterate on technology, the strict enforcement of non-competes lock away the talent entrepreneurs need. This results in both entrepreneurs, and their potential employees, unable to reach their full potential.

Within entrepreneurship, non-compete agreements can hinder the creation of new businesses in several ways. In addition to the way non-competes directly prevent competition between a former employee and employer, entrepreneurs can be dissuaded from starting new businesses, even if they do not expressly violate the terms of their non-compete agreement.

MIT professor Matt Marx describes this as a “chilling effect”, where a prospective entrepreneur decides not to start a business or takes a lower paying job in a differentiated field because they fear the consequences of legal action by their previous employer. Even when the non-compete is thought to be too broad or expansive to hold in court, subjects of non-competes are hesitant to test them. Ironically, entrepreneurs also see the value of non-competes, and use them with their own employees, even after decrying the barriers created by non-competes.

But non-compete agreements don’t just act as anchors for an economy. In fact, there are ways in which non-competes can promote innovative activity. When firms trust that non-competes will be upheld, they engage in riskier R&D projects. Non-compete agreements perform the function of adding to the protection of the intellectual property of the firm and the investment they make in their employees. It reduces the risk that employees will leave and take the fruits of the inventive activity with them.

From a policy perspective, non-compete agreements are the purview of state governments. Somewhat famously, California enforces almost no non-compete agreements, which some have theorized is a component of its overall startup culture. Other states have comparably strict enforcement of non-compete clauses. 

Recent policy efforts have been matriculating towards weaker non-compete enforcement. Massachusetts last year had a strong debate about whether a non-compete agreement ban would be a net positive or negative, with the bill dying in the Massachusetts House of Representatives. This year has seen bills to ban non-competes introduced in Michigan and Washington and  reintroduced in Massachusetts

The presence and enforcement of non-competes matters for business, entrepreneurs, and innovation. When individuals cannot disengage from employment to start new businesses that drive economic growth, the economy suffers. When firms are dissuaded from risky R&D projects that could spur radical innovations to improve the quality of life, the economy also suffers. 

Balancing these examples, and the multitude of other economic considerations that result from an issue like non-compete enforcement, is the challenge for policymakers. Policymakers that understand how non-compete agreements affect new business formation and the value of firm’s intellectual assets can design policy that both protects a firm’s investment in their employees, as well as stimulates economic growth.   

For more information on non-compete agreements, check out Kauffman’s Policy Digest: Rethinking Non-Competes: Unlock Talent to Seed Growth

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chris jackson

Chris Jackson

Chris Jackson is a research assistant in Research and Policy for the Ewing Marion Kauffman Foundation, assisting in the understanding of what policies and environments best promote entrepreneurship and education in the pursuit of economic growth.