Do Non-Compete Agreements Shape The Takeover Market?

On April 23, 2024, the U.S. Federal Trade Commission (FTC) issued a ruling that bans U.S. employers from subjecting their employees to non-compete agreements (NCAs). A slight exception allows existing non-competes for executives (defined as those earning above $151,164 a year) to be grandfathered, but any new ones would be void. The FTC’s ban on non-competes has received considerable media attention; legal challenge to the ruling is already underway. What exactly are non-compete agreements and what is the relevance of the FTC’s regulatory move for the world of corporate governance? 

NCAs are clauses in employment contracts that restrict a former employee’s ability to work for a competitor or establish a competing business for a period of time upon leaving the employer. The primary purpose of such agreements is to protect employers’ proprietary information, thereby encouraging employers to invest in human and intangible capital. Non-compete clauses are particularly common for corporate executives, with up to 80% of chief executive officers (CEOs) covered by NCAs.

Prior to the FTC’s move, non-competes were governed at the state level: individual states’ legislatures and judiciaries decided whether NCAs are allowed at all, how broad they can be, and how to enforce them in various situations. With just a few exceptions – most notably California – states generally allowed the use of NCAs. Therefore, the FTC’s decision to ban NCAs nationwide is notable not only because it is the first time that the regulator attempts to govern them at the federal level, but also because it represents a major regime shift for NCAs: from valid to unenforceable.

The costs and merits of NCAs for the economy are multi-faceted. Generally, researchers have focused on their impacts on worker mobility and wages, as well as on firms’ incentives to invest in intangible capital and to innovate. In our recent study “Non-Compete Agreements and the Market for Corporate Control”, we examine a more indirect but nevertheless consequential way in which NCAs impact the real economy by altering the incentives of top executives. It turns out that non-competes have implications for the market for corporate control, or the takeover market.

The link between NCAs and the market for takeovers that we hypothesize rests on two basic premises. First, greater enforcement of non-competes means higher personal costs for executives, especially if they get dismissed. Second, dismissal is the typical outcome for a top executive whose firm is taken over. It is therefore natural to hypothesize that executives subject to more enforceable non-compete agreements would become more averse to being targeted for a takeover. We test this prediction using data on U.S. public firm takeovers over the period 1981-2013 and changes to NCA enforcement regimes in various states. Specifically, we compare changes in takeover-related outcomes for firms headquartered in states that reform their NCA enforcement regime vs. contemporaneous changes in the same outcomes for firms headquartered in non-reforming states (and controlling for other firm-level and state-level variables). We focus on same-industry takeovers – those where the bidder and the target come from the same or related industries; such deals entail a greater degree of operational overlap and a higher likelihood of executive dismissal.

Our key findings are as follows. First, when NCA enforcement tightens, we see fewer takeover attempts. It appears that executives preclude takeover discussions in their infancy. Second, when bids are made, an increase in NCA enforcement is associated with a higher incidence of hostile bids, i.e. those that are met with resistance from target management. Third, tightening of NCA enforcement is associated with higher takeover premiums – as if the target management attempts to defeat the offer by asking high, or at least tries to offset personal costs of likely displacement by higher gains on any shareholdings. Fourth, tightening of the NCA enforcement regime is associated with a higher incidence of deal cancellations, whereby announced bids are later withdrawn. The overarching conclusion is that the use of NCAs and their enforceability appears to make managers more averse to takeovers.

The resistance we document takes different forms, some of which benefit target shareholders (higher premiums) and some of which preclude shareholder gains (bids that never see the light of day, cancelled attempts). Therefore, whether NCAs result in a sizeable agency cost for target shareholders is difficult to conclude. Moreover, NCAs can have more direct impacts on shareholder value through channels such as promoting investment in intangibles, etc. Nevertheless, our findings should raise boards’ awareness of the potential incentive misalignment arising from the use of NCAs in executive contracts in the context of takeovers. Possible remedies could include carefully crafted golden parachutes or takeover-related compensation, as well as executive stock ownership – albeit these also come at a cost (e.g., golden parachutes raise the cost of acquisition for a potential bidder).

As noted above, NCAs can affect the real economy in multiple ways. We do not take a stance on the FTC’s move to ban non-compete agreements – neither on its legal aspects nor on its potential effect on societal welfare. However, our analysis does offer a glimpse of what we might expect from the ban in terms of the takeover market: more M&A activity. Thus, taking our results at face value, our findings would suggest that banning non-compete agreements could actually promote consolidation in product and labor markets through more same-industry takeovers. This is a noteworthy unintended consequence, considering that the stated goal of the regulator was to increase competition for labor.

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By Andrey Golubov (Rotman School of Management, University of Toronto), and Yuanqing (Lorna) Zhong (Rotman School of Management, University of Toronto)

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