October 5, 2017
As a general rule of thumb, every franchisor will want to build a non-compete into their Franchise Disclosure Document (FDD). Once you give a franchisee the complete playbook to running and operating your successful business model, you don’t want them to turn around and start running their own offshoot. Which is where the non-compete comes in. It protects you.
The real question here is what are the rules and restrictions around non-competes?
When it applies to franchises, the majority of non-competes will work to limit the franchisee’s ability to operate a similar business once the agreement expires or is terminated. The franchisor will also want to eliminate the option for franchisees to open their own rogue business with the franchisor’s template while running the franchise unit.
To make sure we’re on the same page, let’s start off with a definition from Investopedia:
An agreement between two parties, typically an employee and employer, where the employee agrees not to use information learned during employment in subsequent business efforts for a set period of time. Employers usually insist on non-compete agreements because of the possibility of an employee, upon termination or resignation, working for a competitor or starting a business, and gaining competitive advantage by abusing confidential information about their former employer's trade secrets or sensitive information such as customer/client lists, business practices, upcoming products and marketing plans.
This definition outlines one of the major components of a non-compete: length of time. The missing component is geography. Additionally, the FDD will need to have clear language defining what classifies as a similar business. Despite how appealing it may be, you can’t write a blanket non-compete. To pass legal muster, it needs to have set constraints that eventually expire.
For example, a possible non-compete could say that the franchisee could not operate a sandwich shop within a radius of 50 miles for two years after the franchise agreement is terminated. That outlines industry, geographical constraints, and has a specific time frame.
The ability to enforce non-competes varies by state. Additionally, each state has their own opinion on what classifies as a reasonable non-compete.
Let’s start on the most restrictive side of the spectrum. The state of California does not enforce them. That’s why it’s important to know which state law you’re applying in the agreement. Evoking California law to apply within the FDD eliminates the ability to enforce a non-compete.
For the most part, California is the exception. The majority of other states have a warmer attitude. Typically, the standard state upholds a non-compete as long as it’s not unreasonable. The key is striking a “reasonable” version for each state. When evaluating “reasonable,” most courts look at how viable it is for the individual to fund other forms of livelihood.
Let’s look at how the geographical restriction may look reasonable in one state, but not another. A 50-mile radius in a populated state like Connecticut or Maryland will still give the exiting franchisee opportunity to find populous areas to work in. Have that same restriction in North Dakota or Nevada and you move closer toward the realm of unreasonable.
The next question is what will states do if they find a non-compete to be unreasonable?
Let’s take that first example and make it more restrictive. Let’s say the non-compete limited the exiting franchisee from operating in the restaurant industry within 100 miles for five years. That’s a bit extreme.
Should this non-compete show up in litigation, the court has two options. The first is to throw out the entire non-compete by stating it’s non-enforceable. The second option is to “blue-pencil” the non-compete, which means they re-write it to be more reasonable. Some franchisors will craft a very restrictive covenant while simultaneously picking a non-compete-friendly state law to apply. Based on case law around the issue, they know if it’s unreasonable it will be blue-penciled.
Regardless of how restrictive you want your non-competes to be, it’s important to work with a franchise lawyer to ensure all your legal bases are covered. The last thing you want is to create case law with a non-enforceable non-compete.
If you’re in the process of creating the FDD or working toward franchising your business, contact me today. As both an experienced franchise lawyer and a co-owner of a franchise, I help businesses navigate the legal landscape to creating a profitable and successful franchise.