Non-Compete Agreement

What is a non-compete agreement?

Non-compete agreement (post-contractual non-compete covenant, nachvertragliches Wettbewerbsverbot) is the agreement by which an employee or managing director undertakes not to compete for a certain period after the contract has ended. Other common terms are non-competition clause (Konkurrenzklausel) and non-compete arrangement (Wettbewerbsabrede). During this time, the person bound may neither work for a competitor nor run a competing business. For this, employees receive a statutorily required compensation payment, the Karenzentschädigung (non-compete compensation). Economically, the company thereby buys time: the former employee does not deploy their knowledge and customer contacts at a competitor for a limited period and is paid for this. To be distinguished are non-competes for shareholders and sellers (non-compete clause), to which different standards apply.

During the employment relationship, competition is prohibited anyway, for employees by law and the duty of loyalty, for managing directors by virtue of their position as statutory representatives of the company (organ status). For the period afterwards, a ban arises only by agreement, usually in the employment or service agreement or in a separate arrangement. In funding rounds and company sales, it binds key persons and protects customer relationships; at the same time it creates payment obligations that investors and acquirers factor in.

Non-compete for employees under Sections 74 et seq. HGB

Form and non-compete compensation

The rules are set out in Sections 74 to 75f of the German Commercial Code (Handelsgesetzbuch, HGB). They were created for commercial employees and apply to all employees through Section 110 of the German Trade Regulation Code (Gewerbeordnung, GewO). The ban requires written form, and the employer must hand the employee a signed document containing the agreed terms (Section 74 (1) HGB). It is binding only if the employer undertakes to pay non-compete compensation. For each year of the ban, this must amount to at least half of the contractual benefits last received (Section 74 (2) HGB).

The contractual benefits include, besides the fixed salary, variable pay and benefits in kind such as a company car that may be used privately. Fluctuating pay is taken at the average of the last three years (Section 74b (2) HGB).

Formula: minimum non-compete compensation per year of the ban = (fixed salary + average of variable pay over the last three years + value of benefits in kind) × 50%

If there is no promise of compensation at all, the ban is void according to case law, that is, without effect for both sides. If the promised compensation is too low, the ban is not binding. The employee can then choose whether to comply with the ban and demand the promised compensation or to compete.

Limits of substance and time

Under Section 74a (1) HGB, the ban is not binding insofar as it does not serve to protect a legitimate business interest of the employer. The same applies insofar as it unreasonably hampers the employee's career progress. It may not extend for more than two years after the end of the employment relationship. Protection of customer relationships and trade secrets is as a rule legitimate; the mere intention to weaken a competitor is not. Bans that cover an entire industry worldwide therefore usually go beyond what is permissible.

Set-off and waiver

If the employee earns income elsewhere during the period of the ban, this income is partly set off. The compensation is reduced to the extent that, together with the new earnings, it exceeds 110% of the previous contractual benefits. If the ban forces the employee to change their place of residence, the limit is 125% (Section 74c HGB). Before the end of the employment relationship, the employer can waive the ban in writing. The employee is then free, but the obligation to pay compensation ends only one year after the declaration of waiver (Section 75a HGB).

Non-compete for managing directors: limits under Section 138 BGB

For managing directors of a GmbH (German limited liability company), Sections 74 et seq. HGB do not apply directly, because as an organ of the company they are not employees within the meaning of these provisions. The limits arise from the prohibition of contracts contrary to public policy (Section 138 of the German Civil Code, Bürgerliches Gesetzbuch, BGB) in conjunction with freedom of occupation (Article 12 of the German Basic Law, Grundgesetz, GG). The ban must serve a legitimate interest of the company and may not restrict professional activity unreasonably in terms of geography, subject matter and time. Compensation for the non-compete period is not a statutory condition for validity but is customary in practice. The further the ban reaches, the more its validity depends on appropriate compensation.

Terms of up to two years are widespread; case law views longer bans critically. If a ban is too long only in time, it may be reduced to the permissible extent; if it is drafted too broadly in substance or geography, nullity as a whole is a risk. Set-off of other earnings and a right of the company to waive apply to a managing director only if the contract expressly provides for them.

Non-compete compensation and garden leave

Non-compete compensation and paid garden leave (Freistellung) are often confused. Garden leave concerns the current notice period: the employee receives salary, no longer works and remains bound by the non-compete of the existing employment relationship. Non-compete compensation follows only after the legal termination, for the duration of the post-contractual ban. Six months of garden leave and a 12-month ban therefore keep an executive out of the market for 18 months, at corresponding cost.

Non-competes in due diligence and purchase price

In due diligence, it is examined which key persons are subject to a ban and whether it has been agreed in valid form and with sufficient compensation. An invalid ban does not protect; a valid one causes costs. Acquirers often treat ongoing compensation payments to former employees like debt in the purchase price calculation, even if they are not shown, or not shown in full, on the balance sheet. They thereby reduce the equity value, that is, the value of the equity from which the price for the shares is derived.

In a share deal, the purchase of the shares, the company remains the employer and existing bans continue unchanged. In an asset deal, the purchase of the business operations, employment relationships pass to the acquirer under Section 613a BGB with their rights and obligations, including any agreed non-competes.

Worked example: calculating non-compete compensation

The sales director of a software company receives a fixed salary of EUR 96,000 a year. Her commissions in the last three years were EUR 24,000, EUR 30,000 and EUR 36,000. A post-contractual non-compete of 12 months with the statutory minimum compensation has been agreed. After leaving, she takes up a position outside the industry at a monthly salary of EUR 9,000.

• Average commission: (24,000 + 30,000 + 36,000) / 3 = EUR 30,000
• Contractual benefits per year: 96,000 + 30,000 = EUR 126,000
• Minimum compensation: 126,000 / 2 = EUR 63,000 a year, that is EUR 5,250 a month
• Set-off limit: 126,000 × 110% = EUR 138,600 a year, that is EUR 11,550 a month
• Compensation and new salary: 5,250 + 9,000 = EUR 14,250, which is EUR 2,700 above the limit
• Reduced compensation: 5,250 minus 2,700 = EUR 2,550 a month, for 12 months EUR 30,600
• Without a new job: 12 × 5,250 = EUR 63,000

Had the company, together with the termination and with a notice period of three months, waived the ban in writing, the sales director would have been free when the employment relationship ended. The obligation to pay compensation would have ended 12 months after the declaration, that is, nine months after her departure. This gives 9 × 5,250 = EUR 47,250 without and 9 × 2,550 = EUR 22,950 with a new job. A timely waiver thus saves EUR 15,750 (63,000 minus 47,250) or EUR 7,650 (30,600 minus 22,950). This presupposes that the company decides before the end of the employment relationship whether it still needs the ban. All amounts are before tax.

Distinction: non-compete agreement, non-compete clause and non-solicitation

• Non-compete clause: non-compete for shareholders in the shareholders' agreement or for sellers in the company purchase agreement. The standard there is competition law and Section 138 BGB; non-compete compensation is not required.
• Non-solicitation clause: ban on poaching employees or customers. According to case law, a post-contractual customer protection agreement with employees is itself a non-compete and requires non-compete compensation.

Common mistakes

• No promise of compensation. A ban without any promise of non-compete compensation is void for employees and offers no protection at all.
• Variable pay not taken into account. If the compensation is based only on the fixed salary, it is below the statutory minimum and the ban becomes non-binding.
• Waiver declared too late. A waiver under Section 75a HGB takes effect only if it is declared before the end of the employment relationship.
• Employee template in a managing director's contract. Without an express set-off and waiver clause, the company does not have these rights in the case of a managing director.

Frequently asked questions

Is a non-compete without compensation valid?

Not for employees. If the promise is missing entirely, the ban is void; if it is too low, the ban is not binding on the employee. For managing directors, compensation is not a statutory requirement, but its absence is taken into account when assessing reasonableness.

How long may a post-contractual non-compete for employees last?

At most two years from the end of the employment relationship (Section 74a (1) sentence 3 HGB). Insofar as a ban goes beyond that, it is not binding.

May an employee bound by a non-compete work for a competitor in a different function?

That depends on the wording. An activity-based ban prohibits only certain activities, for example in sales, and permits other functions at the competitor. A company-based ban prohibits any activity for a competitor but must be measured against the legitimate interest of the former employer.

Can an employee free themselves from the non-compete after a dismissal?

Under certain conditions, yes. If the employer gives ordinary notice without there being a substantial reason in the person of the employee, the employee can release themselves from the ban within one month by written declaration. This does not apply if, on giving notice, the employer undertakes to pay the full benefits last received for the duration of the ban (Section 75 (2) HGB).

How is the non-compete compensation calculated?

For each year of the ban, it amounts to at least half of the contractual benefits last received and is paid at the end of each month. If the former employee earns income elsewhere, it is reduced to the extent that the two together exceed 110% of previous pay; on request, they must disclose their earnings.

What applies if a job applicant is still bound by a non-compete?

The ban binds only the applicant, not the new employer. The former employer can, however, demand that the applicant desist and does not have to pay compensation for the period of the breach. New employers therefore ask about existing bans and check whether the planned activity is covered at all.

The Roemer Capital view

When preparing a company sale, Roemer Capital compiles which key persons are subject to a post-contractual non-compete and what compensation would fall due on their departure. It also records how many bans from earlier employment relationships are still running. These amounts are included in the bridge from enterprise value to purchase price before an acquirer asserts them as a deduction.

If founders continue as managing directors after the sale, Roemer Capital coordinates with the company's law firm how the ban in the service agreement and the seller's ban in the purchase agreement work together. The aims are the same scope of subject matter, no gap between the terms and no double binding without reason. The employment law review of individual clauses is a matter for the law firm.