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Are Non-Competes Bad For Entrepreneurship?

Are Non-Competes Bad For Entrepreneurship?
Credit: De Focus/Shutterstock

Non-compete agreements, which limit employees' abilities to leave their current organization to launch a rival business, can stymie entrepreneurship, according to new research.

The study, which will appear in an upcoming issue of the journal Management Science, revealed that in states where there is strict enforcement of non-compete agreements, fewer employees leave their employer to start their own businesses in the same industry.

Non-competes are agreements between an employee and his or her employer that prohibits workers from joining a company or starting a business that directly competes with the employer. There is typically a time restriction, such as one or two years, and a geographic restriction, such as within the same county or within a certain radius.

Natarajan Balasubramanian, one of the study's authors and an associate professor of management at Syracuse University, said the study shows that strict enforcement of non-competes limit "spin-outs" — businesses started by employees in the same industry of the firm they are leaving.

"We also find some evidence that suggests strict enforcement of non-competes is associated with more spin-outs formed outside the parent company's industry, but that increase does not appear to offset the reduction in the number of spin-outs in the same industry," Balasubramanian told Business News Daily. "At a minimum, I think non-compete enforcement changes the nature of entrepreneurship."

Not all states, however, have the same take on non-compete agreements. Some strictly enforce these pacts, while others, like California, have banned them. [See Related Story: Go Ahead, Take the Risk: Entrepreneurship Pays Off]

"The trade-off is between allowing workers the freedom to move across jobs versus protecting investments made by businesses that could be lost if workers moved to a competitor," Balasubramanian said. "There is also a more philosophical difference across states about the extent to which governments should intervene in private contracts."

Balasubramanian said California's lack of non-compete enforcement has been cited as one reason for the startup culture of the Silicon Valley.

"New ideas are moving from place to place constantly, which some have suggested helps contribute to the vibrant economy in that area of the country," he said.

The research did find strictly enforcing non-competes does tend to weed out some of the poorer quality businesses. The study shows that the spin-outs that do launch tend to be larger and better performing.

If businesses focus narrowly on the impact of non-compete enforceability on entrepreneurship — rather than on how non-competes impact things like wages and the ability of employees to freely move from one company to another — stricter enforceability could be viewed as a positive since it doesn't seem to deter entry of "better" ventures that are likely to grow larger and last longer, Balasubramanian said.

"However, we must also be aware that too much weeding out could potentially reduce competition among businesses which, in turn, could eventually hurt consumers," he said.

The study was co-authored by Evan Starr, an assistant professor at the University of Maryland, and Mariko Sakakibara, a professor at the University of California, Los Angeles.

Chad Brooks

Chad Brooks is a Chicago-based writer and editor with nearly 20 years in media. A 1998 journalism graduate of Indiana University, Chad began his career with Business News Daily in 2011 as a freelance writer. In 2014, he joined the staff full time as a senior writer. Before Business News Daily, Chad spent nearly a decade as a staff reporter for the Daily Herald in suburban Chicago, covering a wide array of topics including local and state government, crime, the legal system and education. Chad has also worked on the other side of the media industry, promoting small businesses throughout the United States for two years in a public relations role. His first book, How to Start a Home-Based App Development Business, was published in 2014. He lives with his wife and daughter in the Chicago suburbs.