Covenants Not to Compete in Employment Versus Business Transactions

August 30, 2021

Non-compete agreements are common between employers and employees (“employment covenants”), and between buyers and sellers of businesses (“transaction covenants”). Section 103.465 of the Wisconsin Statutes governs employment covenants and requires employers only require restrictions that are reasonably necessary for the protection of the employer. To quote from the statute, “Any covenant . . . , imposing an unreasonable restraint is illegal, void and unenforceable even as to any part of the covenant or performance that would be a reasonable restraint.” Courts scrutinize employment covenants closely because employers typically have a bargaining advantage over employees when negotiating such contracts, and the covenants can significantly affect an employee’s ability to freely seek other employment.

Transaction covenants arise when the buyer of the goodwill of a business seeks to prohibit the seller from engaging in competition that could undermine the value of the goodwill. For example, if Fred sells Fred’s Pizza Parlor to Mike as a going business, Mike will likely require that Fred agree to refrain from starting or working for a competing pizza business within a certain distance of Fred’s Pizza Parlor. While this covenant will have an effect similar to an employment covenant by limiting Fred’s ability to work in the pizza business, it is not governed by section 103.465 and its terms can be more reaching. This is because Fred and Mike presumably had equal bargaining power to enter into the covenant as part of the overall transaction, and because Fred agreed to the restrictions to make his business more valuable to Mike.

Because courts closely scrutinize employment covenants for reasonableness, their terms are typically more limited than transaction covenants. For example, an employment covenant will typically limit post-employment competition to two years or less. By contrast, transaction covenants often extend post-transaction competition to three years or more.  Another difference is the consideration stated for the agreement. For an employment covenant, the consideration is the offer of employment. For a transaction covenant, the consideration is the parties’ willingness to enter into the transaction.

As recently demonstrated in Auto-Chlor System of the Mid-South, LLC. v. Doug Ehlert, no. 2020AP1768, 2021 WL 3412916 (Wis. Ct. App. Aug. 5, 2021), close attention must be given to structuring the covenant not to compete to accurately reflect its purpose. Auto-Chlor purchased a competing business from Ehlert’s parents. Ehlert worked for the business and was a key employee. As part of the deal, Auto-Chlor agreed to hire Ehlert and required that Ehlert enter into a covenant not to compete that contained a five-year restriction on competition. Auto-Chlor eventually sued Ehlert for breach of the agreement. The circuit court granted Ehlert summary judgment on the basis that the covenant violated section 103.465. On appeal, Auto-Chlor conceded that the covenant was unenforceable under section 103.465 (most likely on the basis that five years is too long a period of restriction, although the opinion does not say). Auto-Chlor contended that section 103.465 did not apply because Auto-Chlor premised the covenant on a business transaction; the purchase of the business where Ehlert was a key employee.

The court of appeals sided with Ehlert because the covenant included a fatal flaw: the consideration included both Auto-Chlor’s willingness to enter into the transaction and Auto-Chlor’s offer of employment to Ehlert. The court noted that section 103.465 applies to any agreement by an employee not to compete with his or her employer during the term of the employment or after the termination of that employment. The court also noted the agreement required Ehlert to sign it as a condition of employment with Auto-Chlor. As a result, the court ruled that the agreement comes within the statutory language of section 103.465. The court reached this conclusion despite the agreement including a recital that stated, “As a material inducement for the Company to enter into the sale of Assets Agreement, the Company is requiring Mr. Ehlert to execute and deliver this Agreement.”  Instead, the appellate court based its decision on a provision in the agreement, which stated, “(d) Upon execution of this Noncompetition Agreement and the Auto-Chlor Employment Agreement, Mr. Ehlert will enter employment with Auto-Chlor System of the MidSouth, LLC, as an account executive.” The court determined this statement was enough to establish that Ehlert was required to sign the agreement as a condition of employment and therefore, the agreement came within the purview of section 103.465.

Bottom Line

Careful thought must go into drafting covenants not to compete in order to ensure that the provisions are appropriate for the agreement’s context.