A restrictive covenant is a promise included in a contract or agreement that somehow restricts one of the parties from doing something. In business, restrictive covenants often apply to employee contracts. They can help protect business operations after an employee leaves the company.
Learn more about how restrictive covenants work for businesses and some examples of common types you're likely to see.
What Is a Restrictive Covenant?
A restrictive covenant could be any form of contract or agreement that restricts the things that at least one of the parties can do. The two most common situations in which restrictive covenant apply are real estate contracts and employment contracts. These covenants restrict the ways someone can use property, or they may restrict the ways someone can use sensitive company information.
How Does a Restrictive Covenant Work?
Restrictive covenants work just like any other covenant or contract. The agreements are clearly written for both parties, and once they both understand the terms of the agreement, they'll sign the document to make it official.
The actual details of the restrictive covenant will vary greatly depending on the individual situation. In business contexts, there are three basic types of restrictive covenants:
- A non-compete agreement restricts the activities of one party who agrees not to compete with another, often their employer, for a specific period of time and within a specific geographical area.
- A non-disclosure agreement restricts communications. One party agrees not to disclose business secrets, trade secrets, proprietary processes, or other information related to the business.
- A non-solicitation agreement restricts marketing and hiring activities by one individual in a business agreement. One party agrees not to solicit employees or customers from the other.
Some break down the non-solicitation agreement into two categories. In that case, non-solicitation covers the solicitation of customers, while a non-raiding agreement covers the recruitment of employees for a competing business.
Restrictive Covenants in Employment Contracts
The most common restrictive covenants are found in employment contracts. These covenants commonly prohibit employees from taking specific actions either during the term of employment or for a period after employment ends.
Non-compete and non-disclosure agreements are most commonly found in employment situations, particularly when a business has invested heavily in an employee through signing bonuses, extensive training, and other forms of incentives and investments. The employee may be entrusted with confidential information, and the restrictive covenant helps protect that information in case the employee quits.
Other Examples of Restrictive Covenants in Business
Restrictive covenant agreements may also be integral to other business relationships besides the employee-employer relationship. Partnership agreements often include non-compete clauses and non-solicitation terms as well as non-disclosure provisions. This is especially common with new owners or partners coming into an existing business.
A new owner may want the former owner/seller to sign a non-compete agreement restricting them from competing as part of the sale of a business. The new owner might also want to restrict the former owner's ability to hire away employees or solicit existing clients or customers or restrict disclosure.
Restrictive Covenants Can Be Too Restrictive
Many restrictive covenants are legal, but in some cases, courts have invalidated specific aspects of a restrictive covenant. When restrictions are particularly exacting and limit the ability of an individual to do business, then courts may refuse to hear cases regarding breaches of the covenant.
In a non-compete agreement, for example, the value of what is given up should be relatively equal to the benefits received. For example, a business owner signing a non-compete may receive some specific compensation as part of the sales contract.
State laws govern restrictive covenant agreements, and these laws can vary from jurisdiction to jurisdiction in what they allow and what terms will not be upheld. California, for example, has a ban on non-compete agreements. Even when an employee signs a non-compete contract "voluntarily" or "for consideration received," the covenant is not upheld by California courts.
Speak with an attorney in your state if you're contemplating drafting or entering into a restrictive covenant agreement. Its ultimate enforceability will depend not only on your state's laws but prevailing trends in your area, so this is one area in which it's especially important to seek professional help.
Restrictive Covenants and Taxes
For tax considerations, a non-compete restrictive covenant is considered a section 197 intangible. The cost of a non-compete agreement as part of buying a business must be amortized over 15 years. The amortization period begins with the month the agreement was signed or the month the business began producing income, whichever is later.
Restrictive Covenants in Real Estate
A restrictive covenant (sometimes called a deed restriction) in real estate is a deed that includes restrictions on the use of the property. Restrictive covenants are common in condominiums and other limited-access community situations in which all properties are similar—the condo association or homeowners association wants to keep the property values up.
These real estate restrictions might include limiting what you can do on the property, such as banning home-based businesses and pets or determining where you can park your cars. They could also restrict the way you renovate the property by specifying architectural guidelines, square footage, paint colors, or other similar mandates.
Anyone who buys property in a deed-restricted area must agree to the restrictions. Violations usually result in lawsuits, because the association doesn't want to let other property owners think that they can ignore the restrictions.
When real estate restrictive covenants carry over from one property owner to the next, the restrictions are said to "run with the land."
Restrictive covenant documents will usually outline the fines imposed for violations, which could include a lien on the property. Just like employment covenants, these issues can be fought in court.
- A restrictive covenant is an agreement that restricts what someone can do.
- Restrictive covenants are most common in employment contracts and real estate deeds.
- A court may choose not to enforce restrictive covenants if they are deemed too restrictive.