How Noncompete Clauses Can Backfire

Enforceability of Agreements Creates Screening Effect

U.S. companies worried about knowledge leakage should be careful what they wish for when they lobby state lawmakers to strengthen the enforceability of noncompete clauses. New research from the University of Maryland’s Robert H. Smith School of Business shows unintended consequences when the contract addendums are given teeth.

The threat of legal enforcement works great to dissuade less experienced and lower paid workers from striking out on their own within the same industry. But high probability of a legal battle does little to stop proven leaders with greater resources to withstand the challenge.

“High enforceability creates a filter that screens out potential founders who are least likely to succeed,” says Evan Starr, assistant professor at the University of Maryland’s Robert H. Smith School of Business and co-author of the paper. “The best spinouts are still created in states that vigorously enforce noncompetes.”

The screening effect means fewer spinouts overall within the same industry as the parent firm. But relative to spinouts that cross industry lines, the spinouts that emerge tend to start larger, are founded by higher earners, and are more likely to survive their initial years. “Enforceability influences the size, growth and survival of new firms, as well as the characteristics of spinout founders and workers hired by spinouts,” Starr says.

Past research shows a similar pattern when patent laws are strictly enforced. Employee mobility declines, but the most productive and talented inventors still find ways to leave. “Workers with the best resources and ideas appear to overcome constraints that bind them to the firm, whether in the form of patent litigation or noncompete enforceability, whether they are seeking to start a new firm or just move to a competitor,” Starr says.

The new research, published in Management Science, looks beyond employee mobility to the firm level. In the realm of noncompete clauses, the distinction between within-industry and out-of-industry startups is important because enforceability weakens as entrepreneurial activity moves farther away from the parent firm’s sphere of influence.

Size of the parent firm also affects enforceability. “Larger parent firms have more resources to pursue noncompete litigation, and thus they more routinely go after departing employees,” Starr says. “Within-industry spinouts in high-enforcement regions tend to have smaller parents.”

Enforceability also varies by location. U.S. workers routinely sign noncompete clauses in all 50 states, but the agreements are void in certain places like California. Another factor is the specific industry involved. Law firms, for example, are exempt from noncompete clauses in all 50 states.

Starr and his co-authors control for all of these variables, basing their findings on a study of 5.5 million firms created between 1990 and 2008 in 30 U.S. states.

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Screening Spinouts? How Noncompete Enforceability Affects the Creation, Growth, and Survival of New Firms, is featured in Management Science. Authors include Evan Starr from the University of Maryland, Natarajan Balasubramanian from Syracuse University, and Mariko Sakakibara from the University of California, Los Angeles.