Written by Ian Sharp PhD on June 18th, 2019
Ian Sharp here and you are listening to The Good Doctor Sharp on DoctorsInTech.com
Today I'm going to discuss the sleeping giant - non-compete agreements. No cares or thinks about them until it's time to wake up and it's too late, so it's really important you understand them.
A non-compete agreement is an agreement meant to: prevent a professional from earning a living, doing what he is trained to do.
"I put the money in the box... I cranked the lever, and nothing came out!"
"You're puttin' it in all wrong... hold on... I've been doin this a long time... let me try..."
"Okay. Hold on... Hold on... Before you give it a try... you need to agree you're not going to compete with my previous attempt to crank the lever.
I'm a nice guy and I'll let you try. But first, you're going to need to agree to put in the same amount of money I did, its only fair, for the chance to get half of what comes out.... basically we're going to split the difference on whatever money comes out... Now you can't just take all the money that comes out. Once you put the money... Because I put some money in first... I need some money too. It's a hard thing... to find the box, and put the money first"
"Is more money coming out of the box than you are putting in?"
"There are indications that it will"
"Uhh... No thanks. Nevermind then."
"Please.. Just put the money... I PUT IN SO MUCH ALREADY, which means all the money is right about to come pouring out.
All you need to do is have the money... and put the money... like me. We might get money... But I'll get more money..."
"Thanks, but no thanks."
"You know, you could get money ?!"
"There's other boxes and cranks right here... In fact we're surrounded by millions of boxes and cranks."
"No! Don't use those! They don't work... Crank this busted box I cranked... and split me the money... It'll work. But don't compete. Got it?"
"Are you going to show me "the correct way" to crank the lever?"
"I locked a bunch of money in a vault yesterday."
"Did you look today to see if more money
"No it's the same. But I'm going to look inside again tomorrow."
There is a CEO of a brand new startup and he comes to you, because you invest in startups. The CEO has an idea for a sandwich. The CEO has no culinary experience, but it doesn't matter to you because you know a great chef that will work for you.
The CEO plans to talk at the Chef while the Chef works. The plan is for everyone to own 33% of the chef's sandwich once he's done making it.
Because you invest in startups, you like the idea,
but you don't want the CEO or chef to leave you and benefit from making sandwiches without you,
so everyone is forced to sign a non-compete agreement before you give them the money. The name of the company is "No Sandwich, Know Bounds INC". You think to yourself....
If I invest money in the CEO, to hire a chef, to make the sandwich... And the chef doesn't make an edible sandwich... I still get to 33% of the sandwich?
Of course, we all own 33% of the sandwich. If the sandwich is good, I'll profit forever and if the sandwich is no good... then it's even better for me.
Everything changed a lot over that year; the restaurant, the ingredients. Before they knew it,
the CEO and chef were taking idyllic walks along the beach with their half-made sandwich in hand.
Wind blowing, filling their sandwich with granular sand crystals.
12 months later the sandwich comes back and it is filled with sand.
Who do I blame that we have a sand sandwich for all our efforts? Can I blame the CEO? He said he told the Chef exactly what he wanted, "an amazing sandwich". Can I blame the Chef? I think the Chef tried doing exactly what the CEO asked of him but I can't be sure. Was it because the CEO wasn't asking him to make a sandwich?
Was it because what the CEO kept changing what the sandwich should be?
It sounded like they had big ideas, and that's what you liked about it.
You can't blame yourself for putting a CEO in charge of making a sandwich... who has no experience making sandwiches....
I think I can can blame the Chef for taking long romantic walks along the beach with the sandwich... He couldn't make the sand taste any good.
Then maybe I can blame the CEO for doing a bad job at making sandwiches.
You think you need a new Chef to make better sand. Your mind fixes on the Chef you wished you had chosen in the first place.
I hate this Chef, I want my money back.... because my money has value and his sand'wich, so he gave me a bad deal.
You put the money. You left the money with those people.
You peeked your head back in every 2 months. After a year you didn't see a good sandwich and your money was gone. Now you want your money back.
You want to try your own Chef with the CEO, but you can't because you also signed the non-compete.
The CEO doesn't want to work with you because you're out of money.
The chef could definitely make a great sandwich, without being forced to put sand in it, but no one believes him (amazing!) - and he's banned from making any kind of sandwich
unless its dictated by the CEO and you now anyway, so you don't have to worry.
The Chef certainly can't be allowed to make a sandwich the way he'd like to in his own restaurant without any of us - what the hell does a Chef know about sandwiches?
I believe the work done by the CEO and Chef was not valuable, because their work resulted in a sand sandwich!
I believe the money I gave was valuable, because I could've bought a whole truckload of sandwich.
I don't care that my money was traded for sand.
I still hold onto belief that my money was valuable, and their efforts were not valuable.
I know if I burn a bunch of money in a bonfire I shouldn't expect to have an amazing sandwich magically appear.
But for whatever reason... I think if I burn a bunch of money in a bad business, that I deserve some kind of good outcome.
You forgot that money in a box doesnt make great things happen.
The chef knows he's not allowed to earn a living by making sandwiches again, without the risk of getting sued, so he doesn't even try.
You know this and that him and the CEO are both desperate for money.
The CEO knows he can't try again with a new Chef because he signed a non-compete.
You know you can't start again with a new CEO or a new Chef. You're all stuck together
You're an investor, and you don't really have a choice, so you say...
"I'll give some money again... and you should be lucky that I'm even giving you less money...
to try and remediate this sandwich and make the one the CEO really envisioned".
You propose to give the same amount of money to own 66% of the company, the CEO 16.5% and the chef 16.5%.
This is a great-deal for you and it makes you happy they made a bad sandwich, because it gave you the opportunity to own more of the company that you ruined.
But wait... Neither the chef, nor the CEO want to make a whole sandwich all over again, especially since they will have to do more work to own less of the company they are creating.
You blame the chef and CEO for the disappointment. You don't want to give up too soon, so you say:
"I believe in the idea of the sand sandwich. Take my money. Keep going."
"That's a bad deal" they say. "We'd rather start again with another investor and try again and split it the same way, 33% for each person."
"...or you can invest the some money again again and we'll see what happens.
Let's do the same thing again and expect a different result
because we know more this time, we didn't know what we didn't know before, but now know more, and that's fair"
Nobody likes the deal... because they all signed a non-compete... and they're stuck with eachother.
The chef does not want to continue to work just as hard for half as much reward.
The CEO does not want to do whatever he did before again for half as much reward.
The investor certainly does not want to put in the same amount of money again for the same payout.
You get paranoid:
"If I find out that Chef is making sandwiches I'll sue him!"
You get evil:
"I know, took away the Chef's ability to make a living making sandwiches...
They've got bills to pay... They'll accept whatever I give them!"
If you are anyone... particularly anyone in a small startup - never sign the non-compete.
It's bad for everyone.
- Stay free to earn a living doing what you are trained to do. Stay free to compete in a free market, if you can still make the free market exist for yourself.
- Stay free to explore working with new people
- Stay free to invest with and in other people
I've never seen a group of people get something absolutely right the first time. Never.
The rest of this article lists out a few of the major known deleterious effects of non-compete agreements on the national economy at scale, which includes startup companies.
- states that enforce non-competes experience a lower return on venture capital investment
Samila, S., and O. Sorenson. 2011. “Non-compete Covenants: Incentives to Innovate or Impediments to Growth.” Management Science 57, no. 3: 425–38.
- diffusion of knowledge is muted where non-competes are enforceable
Beleznon, S., and M. Schankerman. 2011. “Spreading the Word: Localization of University Knowledge Spillovers.” Working paper.
Florida has subpar education with limited economic opportunities. Could this in part be due to the non-compete policies? Enforcement, of non-competes in Florida is quite common.
- non-competes are less favorable for young unestablished businesses
Non-compete Agreements: Barriers to Entry … and Exit? Matt Marx,
Bureau of Economic Research, MIT Sloan School of Management
- engineers ... involuntarily leave their technical field to avoid a potential lawsuit.
The Firm Strikes Back: Non-compete Agreements and the Mobility of Technical Professionals, Matt Marx, American Sociological Review, August 24, 2011
Could this have an effect on a professionals livelihood, the economy and the success of startups in general?
- non-compete agreements are responsible for a “brain drain” of knowledge workers out of states that enforce such contracts to states where they are not enforceable
Regional disadvantage? Employee non-compete agreements and brain drain, Matt Marx, Research Policy
Volume 44, Issue 2, March 2015
California and silicon valley is known as the bedrock of technological innovation for the USA and all over the world. There may be at least some influence of the dynamic growth related to California's choice to never enforce non-compete agreements.