Since 1872, the California Supreme Court has applied a bright-line mandate holding covenants not to compete invalid and unenforceable, unless the covenant is being sought as a means to protect goodwill in connection with the sale of a business. California’s Business and Professions Code permits an exception to the blanket non-enforcement of covenants not to compete. The exception provides that any person who sells the goodwill of a business may agree with the buyer to refrain from carrying on a similar business within a specified geographic area in which the business has been carried on, so long as the buyer or any person deriving title to the goodwill or ownership interest from the buyer, carries on a “like” business in that area.

Solution: Severance Arrangement

In light of this rather narrow exception to the bright-line rule, what do California employers do to prevent key employees from stealing clients and customers? One method, and really the only method, that is used in California is to provide a severance arrangement whereby the severance payments are made as salary continuation over a specified period (e.g., one year) and are conditioned on non-competition. Under the arrangement, the former employee is being paid to refrain from competition. The agreement is entered into with the understanding that if the employee actively competes, either by accepting employment with a competitor or by calling upon clients and customers, the salary continuation payments will cease immediately. A California court has yet to invalidate this type of arrangement.

An extension of the arrangement, which is more on the cutting edge, is to provide in a bonus plan, for example, that 15% of each annual bonus payment will be held back and paid as salary continuation upon termination of employment, with payment conditioned on non-competition. The employer, however, must provide a clear understanding in the plan documentation, specifying that the 15% hold back is not “earned,” unless the employee refrains from competition during the post termination salary continuation period.

The salary continuation/severance plan approach is fairly common in California as means to deter competition. The bonus plan approach is essentially the same concept but the salary continuation payments are “funded” through the achievement of performance goals that presumably involve higher earnings, profitability, etc. In either case, the position of the employer is that the arrangement does not restrain the employee from engaging in a trade or business (i.e., the California public policy), but rather the employee is provided valuable consideration (i.e., salary continuation payments) to refrain from competition.