To explain when competition between businesses can legitimately be restricted, Grid Law founder David Walker provides an assessment of the potential triggers behind non-compete clauses.
Business is competitive and in most situations, competition is encouraged. Competition between businesses leads to greater innovation, better customer service and ultimately ensures that consumers have more choice and receive better deals.
To help promote this, we have laws which prevent anti-competitive behaviour. But, there are a few situations when competition can legitimately be restricted.
Most people will be familiar with restrictive covenants in employment contracts. When an employee leaves one job there will often be a restriction in their contract preventing them from immediately going to work for a competitor.
However, employment contracts are not the only place where you find restrictive covenants. As you will see below, you can find similar restrictions in a wide range of other business contracts too.
These restrictions (often known as non-compete clauses) are, by their very nature, a restraint of trade and anti-competitive so the automatic presumption is that they’re not enforceable. But, if three conditions are fulfilled, they can be legally binding.
Let’s take a look at what these three conditions are.
First, there must be a legitimate business interest to protect.
So, if, for example, someone is buying a business, there will almost certainly be a restriction on the seller preventing them from setting up a new, competitive business. The legitimate interest being protected is the goodwill associated with the business. Without the restriction, the target business will be worth considerably less to the purchaser.
Another example is when a franchise agreement comes to an end. Without restrictions on the outgoing franchisee, the franchisor may find it difficult to find a new franchisee to take their place. If the outgoing franchisee can set up a rival business in the same locality using all of their knowhow and contacts it devalues the whole franchise system.
Second, the restrictions must be no wider than is necessary to protect those legitimate business interests. This means the restrictions have to be reasonable and they will most likely be limited in time, geography and the activities that can or can’t be carried out.
What is “reasonable” is always open to debate (and often leads to disputes) and will very much depend on the circumstances. It may be reasonable to prevent a business consultant working with a competitor business for six months, but following the sale of a business it may be reasonable to prevent the seller setting up a new business for five years.
The area covered by the restriction will also depend on the type of business. For example, it would be reasonable to put a geographic limitation on an outgoing franchisee of a coffee shop where locality is a key ingredient of success. But, it wouldn’t make sense to limit the location of another business which sells globally, mainly online.
Third, the restrictions must not be contrary to public policy. This normally relates to the consumers and the customers of the business. Would they be unduly affected if there was a restriction on trade? If they are, the restriction is unlikely to be legally binding.
So, how do you find that fine line between non-compete clauses being enforceable or not?
Start by being as specific as you can about the interests you’re trying to protect. For example, are you trying to protect trade secrets or are you trying to protect a local client base?
When you know what interests you’re protecting, it’s easier to think about what’s reasonable. You can think about the length of time the restrictions should be in place, the geographic area and the activities being restricted.
Assuming the restrictions are legally binding, how do you go about enforcing them if they are breached (or you find out they are about to be breached)?
First, you must act quickly. Any delay in taking action could limit the options available to you.
For serious breaches, where there is likely to be irreparable damage to your business, you may be able to obtain an injunction. An injunction is a court order which prevents someone from taking a particular action. If an injunction is granted, it’s usually on a temporary basis until both parties have a chance to prepare for a full trial.
Sometimes, an injunction won’t be appropriate (or the court might not allow it) so instead you will want to claim compensation for the damage being caused.
You can calculate the compensation you are due in three ways:
- If you can prove your loss in financial terms you can claim that
- If you can prove the other party’s gain, you can claim an account of the profits they have made by breaching the contract
- You may consider a theoretical sum that they would have had to pay to be released from the covenants
Whichever method you choose, you’re trying to determine what sum of money would put you in the position you would have been in had the restriction not been breached.
When negotiating a new contract, restrictions and non-compete clauses are an area where you need to tread very carefully. Think about the three criteria we discussed above. Make sure you are clear about the business interests you’re trying to protect and how far you need to go to protect it.
However, don’t try to go too far. If you do, you may find that the restrictions you put in place have no effect at all.
If you have any questions about restrictive covenants or non-compete clauses, feel free to email me at firstname.lastname@example.org and I’ll happily answer them for you.
Catch up on some of David’s recent Business Advice articles:
- How to ensure your electronic contracts are legally binding
- How to value a claim for a breach of contract
- Intellectual property ownership: Who should own what you create?
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