June 10, 2024

Before Matt Paulson led one of the nation’s fastest-growing businesses, he was an early entrepreneur with a legal challenge to overcome.

After being told a noncompete agreement at an advertising agency was “a standard employment document,” he signed it, and it became an issue when he left the job to start his own business.

“My former employer felt my work was too competitive with theirs and hit me with a lawsuit,” he said. “It was ultimately settled out of court but took months of time and thousands of dollars to resolve.”

Today, his business, MarketBeat, doesn’t require employees to sign noncompetes.

“I don’t believe they are fair to employees and don’t actually help businesses,” he said.

“If someone wants to leave your company and work somewhere else, do you really want them to stick around because legally they can’t work anywhere else in their industry for two years? Plus, if you are trying to legally enforce noncompete agreements, you will develop a reputation for having sued your former employees. It’s just a bad look.”

Employers might not be able to make that decision much longer after a 3-2 vote from the Federal Trade Commission in April to approve a final rule banning noncompetes nationwide in many cases.

The agency estimates one in five Americans work with a noncompete.

The rule allows existing noncompetes for senior executives to remain. Employers, however, are prohibited from entering into or enforcing new noncompetes with senior executives. The final rule defines senior executives “as workers earning more than $151,164 annually and who are in policymaking positions.”

The rule has been challenged legally by the U.S. Chamber of Commerce and other business groups, preventing it from taking effect until those cases are resolved. The groups contend that the FTC doesn’t have the authority to rule on noncompetes, which are subject to state law.

In South Dakota, “noncompetes are widely used,” said Heather Springer, a shareholder at Woods Fuller who practices employment law.

“They have really increased in their usage. … They’ve long traditionally been used for C-suite and for sales people, but what I have seen is an increased use for more common employees, lower-level employees.”

There are good public policy arguments from both sides,” she continued. “I’ve seen them abused, for sure. I’ve had people ask me to draft them for very low-level employees, which I won’t do. But I’ve also seen where they’re really needed. There’s a time and place for them. They can be very valid, and I think there’s been a lot of overreach, and that’s why government is starting to act.”

At Alternative HR, CEO and founder Dan Oakland also commonly sees employers use noncompetes for executive and sales positions.

“They’re trying to protect their business, their customer list, their trade secrets,” he said. “The thought is ‘if I train a strong salesperson or executive, I don’t want them going to the competition and using this information against me.'”

At his firm, Oakland put noncompetes in place for his employees “because I wanted to discourage people from going out and starting a competing consulting business,” he said, adding that he works through some scenarios about side work, for instance, on a case-by-case basis.

Alternative HR’s noncompetes preclude an employee from working in a competitive role for two years after leaving. That’s standard, Springer said. Noncompetes also tend to encompass a certain geographic area.

In working with candidates, “frankly, we don’t see it that often,” Oakland said, adding that in some cases, employees have been hired by employers who later learned a noncompete was in place when the previous employer challenged it.

The rule change still would allow companies to enforce confidentiality or nondisclosure agreements to protect certain competitive elements of the business, he said.

“I think, for the most part, those will still be enforceable,” he said. “A person can’t take a customer list and start calling on those people, so there will still be protections in place for some.”

In 2021, South Dakota lawmakers banned noncompetes for a variety of health care positions, including physicians, physician assistants and nurses. The ban was expanded last year to include a broad range of health care occupations, including pharmacists, psychologists and therapists.

The FTC rule does not apply to nonprofit organizations, meaning noncompetes that still exists for health care executives, for instance, would be allowed.

More broadly, “noncompete clauses keep wages low, suppress new ideas and rob the American economy of dynamism, including from the more than 8,500 new startups that would be created a year once noncompetes are banned,” FTC Chair Lina Khan said in a statement announcing the rule.

“The FTC’s final rule to ban noncompetes will ensure Americans have the freedom to pursue a new job, start a new business or bring a new idea to market.”

While Paulson hasn’t heard of noncompetes holding up startups locally, he points to a 2023 report from the General Accounting Office that “found that strong (noncompete agreement) enforcement environments negatively affect the creation of new firms from founders within their current industry.”

He anticipates noncompetes could be replaced by incentive-based agreements, in which employers might agree to provide a cash bonus to new employees or pay off student debt.

“If an employee leaves within a certain period of time, they will have to pay back the bonus they received,” he said. “These types of agreements are much fairer to employees.”

If the FTC ban is upheld, employers will be required to give notice to current and former employees still within the time constraint of a noncompete that the agreement no longer is enforceable.

While the FTC’s ruling has generated “lots of questions and lots of people evaluating,” there’s no clear direction yet because it’s on hold, Springer said.

“It just depends on the philosophy — we want to get ahead of this or we don’t — and both are very reasonable,” she said. “A lot of my clients have philosophically said ‘We’re not going to enforce these’ … but it really depends on the client and the business approach they have and how sensitive they feel they are to market threats.”