LLC Operating Agreement: Is a Non-Compete Clause Necessary?

October 2, 2019

You and your business partners start a new business and decide to operate it as a limited liability company (“LLC”). Now that you’ve completed the first step of choosing a business entity it’s important to prepare an operating agreement (also known as a “company agreement”). The operating agreement is a a shareholder agreement for limited liability companies. It’s a contract that governs the operations of the LLC and sets forth the ownership interests and other arrangements between the members, including their rights and responsibilities upon the departure of a member. Although departure from the business may be the last thing on anyone’s mind, it is important to plan ahead; an operating agreement is, in many ways, a business prenuptial agreement. A non-competition, or non-compete, clause can help protect the company from harm inflicted if a former member decides to form a competing business.

What Is a Non-Competition Clause?

A non-compete clause protects business assets like trademarks and goodwill, confidential information, and trade secrets by preventing the former member from using the knowledge gained while participating as a member of the LLC to compete against the LLC.

If the operating agreement contains a non-compete provision, a former member can be precluded from engaging in a similar type of business directly or indirectly in competition with the LLC. If the operating agreement does not contain such a clause (and has not signed a stand-alone noncompete agreement), the former member may be free to compete with the LLC.

In addition, the non-compete clause may prevent the member from soliciting the LLC’s employees, clients or customers for business if non-solicitation provisions are included. Noncompete clauses typically are effective during the term of the relationship with the LLC and for some period of time after the relationship has terminated.

Because non-competition provisions place restrictions on the former member’s ability to secure future employment, they will only be enforced if they are not unduly burdensome. Consequently, they must only restrict competition for a reasonable period of time and in a reasonablly limited geographic area. Additionally, the scope of the services the former member may provide in a competing business must not be unreasonably restricted.

Note that the standards for the enforceability of non-compete clauses vary from state to state, so it is important to work with an experienced business planning attorney to ensure your non-compete clause and LLC operating agreement are enforceable. For example, in some states, the LLC statute imposes a duty not to compete on managers and members that must be explicitly waived in the operating agreement to avoid applicability.

Does My LLC Really Need a Noncompete Clause?

Members of LLCs often have intimate knowledge of the business, such as its trade secrets, kn0w-how, confidential information, and customer lists. If members are permitted to compete with the business immediately after they withdraw, and in the same geographical location, the financial success of the original business could be jeopardized.

Although many LLCs are formed by small groups of friends or family members who get along well and trust each other in the beginning, it is important not to ignore the possibility of a dispute arising in the future. Circumstances can–and often do–change, and it is important to try have mechanisms in place to help prevent the undermining of your business. Including a non-compete clause in your operating agreement will help ensure your business is protected against a preventable harm.

We Are Here to Help

If you are interested in protecting your new or existing LLC, we can help you draft or amend your operating agreement to include key provisions such as a non-compete clause, as well as others specifically tailored to meet your business’s needs. Please give us a call today to set up a consultation.