How the FTC’s Final Non-compete Rule Could Hurt VC Returns
The FTC’s final rule banning the use of non-compete clauses in employee agreements could hurt return on investment for VC-backed companies that get acquired, according to corporate attorneys who specialize in corporate M&A. But lawsuits against the new rule stand a good chance of scuttling it before it goes into effect in September, the attorneys said.
By exempting non-competes only in the context of a sale of a company to a “bona fide” third-party buyer, the final rule would not stop employees other than senior executives from going to work for a competitor and taking proprietary information with them, attorneys told Venture Capital Journal. Neither does the rule contain an exception that “expressly permits the use and enforcement” of restrictive terms – including post-service non-competes – in indications of interest, letters of intent or other agreements that have been negotiated before, but not finalized until, the rule were to become effective, said Kevin Passerini, a partner in Blank Rome’s trade secrets and competitive hiring practice.
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One thing that private equity and venture investors should understand is that not only does the FTC’s final rule ban non-compete covenants in employment agreements, but “equity-based restrictive covenant agreements with employee equity holders are also thrown out other than as it relates to sale-based restrictions,” said Passerini at Blank Rome.
The FTC also clarified in the background commentary with the final rule that a “bona fide” sale of “ownership interests” that an employee equity holder has could be the basis for a restrictive covenant like a non-compete. “The problem is they clarified that it can’t be a redemption-type agreement or a transfer to a subsidiary or holding company other than the employer because they say it’s a sort of ‘sham,’” Passerini explained.
That means the FTC is only willing to consider non-competes with workers in the equity-holder context that involve a true third-party sale. However, because these are typically closely held or nonpublic companies, there’s a limited market for the equity to be sold in, likely precluding any sale-based restriction from being exempted from the ban outside the context of a true third-party equity or asset purchase, Passerini noted.
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"How the FTC’s Final Non-compete Rule Could Hurt VC Returns," by David Bogoslaw was published in Venture Capital Journal on May 6, 2024.