(Editor’s Note: This post comes from Mark Garmaise of UCLA Anderson School of Management.)
For most firms, the human capital of their employees is a core asset, but it is one over which they cannot exercise full ownership. Noncompetition agreements (also known as covenants not to compete) are contracts that restrict workers from joining (or forming) a rival company, and they represent one of the most important mechanisms binding employees to a firm. In my forthcoming Journal of Law, Economics and Organizations paper, Ties that Truly Bind: Noncompetition Agreements, Executive Compensation, and Firm Investment, I make use of time-series and cross-sectional variation in noncompetition enforceability across the states of the United States to analyze the effects of these agreements.
I start my analysis by considering two contrasting theoretical models. In the first model (Model A), I study the effects of noncompetition enforceability on a firm that is deciding whether to make a non-contractible partially firm-specific investment in the human capital of its manager. In my second model (Model B), managers also have the option to make a non-contractible investment in their own general human capital. I make use of data on state regulations and the Execucomp database of executive compensation to test the predictions of Models A and B by analyzing the effects of noncompetition enforceability. I first show that noncompetition are quite commonly utilized; I find that 70.2% of firms use them with their top executives. I then perform two types of tests. My time-series tests consider changes in noncompetition enforceability law that took place in Texas, Florida, and Louisiana. These tests employ firm fixed effects to analyze the impact of the legal shifts, controlling for all firm-specific variables. My cross-sectional tests analyze differences in enforceability across all states. I argue that noncompetition law is particularly important to firms with substantial within-state competition since covenants not to compete typically have limited geographic scope and are easiest to enforce in the same legal jurisdiction. I then use the interaction between enforceability and the extent of in-state competition as a measure of the power and relevance of noncompetition law for a given firm. I include state fixed effects in our cross-sectional tests to control for differences between states unrelated to noncompetition enforceability, and I also control for industry effects.
I find that increased enforceability reduces executive mobility. Increased enforceability also results in lower executive compensation and shifts its form toward a heavier reliance on salary. I further show that tougher noncompetition enforcement reduces capital expenditures per employee. I demonstrate that these findings are consistent with an incomplete contracting model that has the following three features: enforceable noncompetition contracts encourage firms to invest in their managers’ human capital, the contracts discourage managers from investing in their own human capital, and managers’ investments have a greater effect than those of the firm.
My empirical and theoretical results show that noncompetition regulations help to determine optimal firm choices on a wide set of issues, including executive pay, the stability of the managerial team, and firm investment strategy.
The full paper is available for download here.
Mark Garmaise is an Associate Professor specializing in corporate finance, real estate, entrepreneurship and banking at UCLA Anderson School of Management