Rules vary significantly from state to state
Employees of cannabis businesses are some of the greatest value drivers of the industry. Team members are on the front line, fighting the black market, protecting against the illegal diversion of product and safekeeping the cash generated from legitimate sales. They ensure that products are consistent, marketable and high quality. And ultimately, they are the ones who interact with customers and patients, combating product recalls, raids and crop failures, and maintaining regulatory compliance.
Naturally, if you’ve assembled a productive, top-notch team — particularly at the executive level — and exposed them to proprietary information, you’ll want to restrict how they may use that information to compete with you if they leave your business.
To that end, businesses should insist on non-compete agreements (sometimes referred to as “restrictive covenants”).
The extent to which non-compete agreements are enforceable varies greatly from one state to another, and is often determined on a case-by-case basis. Understanding state nuances is critical. In California and Colorado, which comprise roughly 79% of the legal cannabis market, courts are the least likely to enforce any contractual restriction on competition. (Notably, if employees are terminated for cause, courts generally disfavor enforcement of a non-compete agreement because terminated employees are not viewed as legitimate business threats.)
In California, non-compete agreements are void as a matter of law, with limited exceptions for specific business entities during the sale or merger of a business. Similarly, Colorado prohibits enforcement of non-compete agreements, with limited exceptions arising during the sale of a business and/or all of its assets, to protect trade secrets, or to recoup training and education costs for those employed less than two years. Thus, if your employees work in California or Colorado and you are concerned about competition, you’ll need to protect proprietary information through confidentiality, nonsolicitation agreements, and/or pre-invention assignment provisions in your employment and operating agreements.
For states where non-compete agreements are permitted, the courts generally enforce only those provisions that: (1) Are reasonable in geographic scope and duration; (2) Protect the employer’s “legitimate business interests”; and (3) Are supported by adequate financial consideration for the employee signing the agreement. Many states place restrictions on the types of industries in which restrictive covenants are permitted, so careful legal analysis is always necessary.
In determining “reasonable geographic scope,” most courts consider the employer’s activities and ascertain the boundaries in which the employer operates. If the business is purely intrastate, a national scope would likely be invalidated. But if the business is truly international (arising with frequency in e-commerce), a global restriction might be upheld. Regarding reasonable duration, courts look to the volatility and longevity of the confidential or proprietary information, and ask whether it is likely to change soon. Tech innovations may lose value quickly, so it may be unreasonable to restrain competition beyond anticipated obsolescence.
In defining a “legitimate business interest,” courts will question exactly why the employer seeks to restrict competition. Confidential business information, client or patient lists, trade secrets and other information generated by the business that can only be lawfully accessed through a business relationship are generally considered “legitimate interests.”
Lastly, non-compete agreements won’t be enforced without “consideration,” meaning something of value provided to the employee in exchange for their approval of the non-compete clause. During the hiring process, an employer’s willingness to hire an employee typically constitutes adequate consideration. But after an employee has been hired, businesses need to provide employees with new terms or benefits (such as a raise, bonus, new title or change from “at-will” employment to “contract employee”) in exchange for the non-compete clause.
Also, if non-competition is truly indispensable, businesses should consider including a “garden leave” clause, which provides continued benefits post-employment, during the restriction period, so that the adequacy of the consideration provided to the employee would be difficult, if not impossible, to challenge.
Once a legal non-compete agreement has been drafted, you may want to ensure the availability of remedies in the event of a breach by including a selection of remedies in the agreement.
These include, for example, equitable relief (such as the ability to obtain a restraining order or other injunction to prevent the employee from competing), or liquidated, pre-measured damages. Consider including a “sunset provision” terminating the non-compete agreement in the event of a regulatory shift that allows interstate commerce. Including a sunset provision conveys a sense of fairness, which would increase the likelihood that the restrictive covenant will be deemed enforceable.
Ultimately, in states where covenants not to compete are enforced, the most critical consideration is the agreement being reasonable — in terms of geographic scope, duration and protection of the employer’s legitimate business interests. Carefully crafting agreements to convey this overarching sense of fairness will increase the probability of enforcement and best protect the critical assets of your business.
Lauren Rudick represents investors and startup organizations in all aspects of business and intellectual property law, specializing in cannabis, media and technology. Her law firm, Hiller, PC, is a white-shoe boutique firm with a track record for success, handling sophisticated legal matters that include business and corporate law.