Issues of labor mobility gained significant attention last year following U.S. bans on non-compete agreements. While the debate on non-competes has many dimensions, this post focuses on how to address firm governance, improve labor welfare, and reduce the loss to firms and the U.S. economy due to non-compete agreements in the high-tech sector.
Part of the problem with non-competes derives from the failure of organizations to recognize and reward employees’ talent and to find effective ways to handle employee separation disputes. Addressing both is important for the effective allocation of the American labor force. In this post, I discuss the adverse impact of limiting labor mobility in the tech industry’s highly skilled labor market and market solutions as alternatives to non-competes. I argue that firms could rely more effectively on incentive contracts and joint ventures with their employee innovators and that improved financial reporting of labor turnover could reduce the need for non-competes.
Consider the relationship between employees and employers in the context of the assignment of property rights in a business setting, on two levels: the individual firm level and the aggregate economy. At the firm level, the goal is to weigh employees’ ideas more effectively when they can create value. At the aggregate level, the aim is to exploit employee ideas that are likely to stay hidden, which would be a loss to the economy. The emphasis on high-tech is important due to the externality of new innovations and the sector’s workforce, the engine behind those innovations.
Information Asymmetry in Employee Quality and Non-Compete Agreements
The economics of hiring from the firm perspective has been analyzed (see Shi, 2023).[1] But the economics of the problem presented from the labor perspective is not entirely clear. There are theories in labor economics on sorting and matching of labor, but workers often don’t know whether they will have innovative ideas and thus might put a low probability on having one in the future. Workers could join firms that prevent them from joining competitors (or from starting their own business) engaged in a related line of work. Thus, high-skilled labor might take jobs at firms that would not reward their potential talents but could prevent them from exploiting their ideas elsewhere.
The discussion could be relevant to features of the internal labor market that have not been studied. The labor market is noisy before hiring, with an employee knowing more about her talent than her potential employer. While firms could invest in their employees, assessing the quality of the labor force is noisy inside the firm as well because some employees could have private information about potentially valuable projects and innovation that their employers do not. To overcome asymmetric information on labor quality, firms need to establish a robust process for exploring employees’ new ideas. The key point is that the organizational challenge to solve informational asymmetry about employees’ ideas exists even in the absence of non-competes. This suggests that a market failure due to asymmetric information requires closer attention in the high-tech sector as it is likely to induce underinvestment.
Consequences of Limiting Labor Mobility
The micro aspect of the issue probably has macro investment implications. Gross domestic product and market capitalization clearly will be higher if more good ideas come to fruition. However, frictions, including non-compete clauses, impede the process for dealing with employees’ ideas. While in good times market capitalization is higher partly because developing ideas get funded, perhaps by venture capitalists, the restriction on mobility could inflict costs on employees and the economy.
Estimating the costs is hard. Also, given the broad definition of the high-tech sector, the fraction of the U.S. work force that is covered by non-compete agreements is not known, although Starr et al. (2023) report that the agreements are more prevalent in high-skill occupations.[2] Reinmuth and Rockall (2023) document that restriction on labor (in this case, inventors’) mobility has an adverse effect on innovation due to friction on knowledge transfer, which weakens spillover or externality.[3] Inventors often are not entrepreneurs investing in or managing their own inventions. Thus, limiting high-skilled labor mobility weakens the matching of inventors and investor-entrepreneurs, which results in a loss to the economy.
Further, non-compete agreements encourage relationship-specific investments that produce industry clusters. The argument is similar to that outlined in Armstrong et al. (2024).[4] Whether tech clusters could reinforce or reduce the consequences of non-compete agreements on innovations remains an open question (see Giroud et al., 2024).[5] For example, a firm could be reluctant to hire someone in the same cluster when her former employer claims that she is in violation of a non-compete agreement, even if the former employer does not enforce the agreement. The adverse effect of a non-compete on innovation proxied by patent filings is related to how easily it could be enforced (see Johnson et al., 2023).[6] The subjective belief of employees about the non-compete is an important factor in employee turnover, even when not enforceable (see Prescott and Starr, 2022).[7] Overall, research shows that non-compete agreements adversely impact innovations, which is expected to have macro-economic consequences.
Employee Attitudes About Non-Compete Agreements
To be sure, some firms have legitimate reasons for relying on non-competes. It is also likely that firms do not focus on non-compete agreements at the early stage of hiring as sharing information up front could deter job seekers (see, for example, the 2023 Government Accountability Office study).[8] Furthermore, a potential hire may not ask about a non-compete agreement because doing so could reduce the likelihood of receiving a job offer. The inference is based on the experiences of 16 employees who were subject to non-competes. They expressed enthusiasm about the job during the hiring process, and once they felt that they might get an offer, the non-compete was given a lower weight in the list of their concerns.
Labor also might have limited attention (see Hirshleifer and Teoh, 2004).[9] In deciding on jobs, candidates could focus on a few key, easily quantified variables, such as salary. Quantifying the cost to the employee of a non-compete agreement is difficult. Workers perhaps put a low probability on becoming innovators. Workers also might be risk averse. The non-compete limits an employee on the upside, where the employee is generating other offers. Risk aversion reduces concern about the non-compete agreement.
Potential Solutions to Enhance Labor Welfare
While the future of bans on non-competes remains uncertain, private solutions such as profit sharing might be more promising alternatives for addressing human resource issues. Mehran and Yermack (1997) argue that awarding stock options with a long vesting period increases employee retention.[10] Because data on broad employee stock option plans were scarce at the time, they documented that the voluntary departure of chief executive officers (CEOs) of S&P 500 firms was less likely when they had more stock options with longer vesting options. Firms could also award employees with restricted stocks [see Mehran (2024) for a discussion][11] or equity-based plans subject to forfeiture if an employee leaves in circumstances that a company deems unacceptable. To the extent that an employee leaves to make more money elsewhere, firms could accelerate vesting of stock options or restricted stocks in the divisions that successfully file for a patent or otherwise innovate. This approach would provide incentives for each individual or team to excel and avoid free riding by other division employees. Thus, while the firm stock price will likely rise upon announcement of a patent filing, only employees responsible for the patented invention can benefit financially in the short term. This approach in effect could partly overcome the difficulty of designing efficient contracts due to asymmetry of information on employee talents.
Mehran and Yermack also note that compensation design is a way to retain employees voluntarily and avoid costly litigation associated with violations of non-competes. Shi documents that CEOs of firms that have non-competes are paid 13 percent more, although no evidence exists of a pay premium for a broad group of employees. Empirical evidence supports the effect of higher pay following patent filings, aimed at the retention of mid-level employees. Thus, paying a premium for the successful outcome of an investment could help retain senior employees (see Kline et al., 2019).[12] Firms could use non-compete agreements and pay premiums jointly.
Another approach to encouraging employees to stay when a firm does not have a robust way to assess employee ideas is to establish a group of independent experts to serve as an intermediary or a facilitator. In this scheme, an employee with an idea could contact the intermediary and pay a reasonable fee to the intermediary to assess her idea (the purpose of the fee is to internalize the cost and thus to limit the flow of poor ideas). The group would assess the idea, and if it was promising, a joint contract would be drawn up between the firm and the employee, specifying, among other features, a profit-sharing plan for a division founded by the firm and perhaps co-managed by the employee. Another option would be for the employee to sell her idea to the firm and negotiate appropriate compensation. The critical point is that the employee could not take the idea with her if the firm agreed to pay for it or fund the project. In addition, the firm could not undertake a project if it did not acquire the idea and without getting employee consent.
Still another approach to limiting the negative consequences of non-compete agreements would be to adjust accounting standards, which could have macro implications (see Hwang et al., 2024).[13] U.S. financial reporting gives discretion to firms about disclosing labor issues. A primary purpose of financial reporting is investor protection. Whether a firm’s share price reflects the presence of a noncompete is unclear. If disclosure of a non-compete clause caused a change in the share price, a firm could adjust its policies accordingly, and a job seeker could make more informed decisions about the possibility of working at the firm. The justification for this approach is the adverse effect of the non-compete on the aggregate economy. Research shows that assignment of intellectual property rights to employers due to legal determination reduces labor turnover (see Armstrong, et al., 2024). Instead of going through a costly process, firms could reward employees or assign property rights through an internal process.
Takeaway
The U.S. economy thrives in part because of tech entrepreneurs, evidenced by the contribution of the top seven tech firms to the value of the stock market. While many good ideas become public, others are never disclosed because of restrictive employment practices. Furthermore, non-compete clauses interfere with labor mobility and, thus, labor’s ability to use its talent effectively and efficiently. Some employees are constrained from innovating both inside the firm (because of limited attention) and outside the firm (because of limited mobility). The approaches discussed above could help reduce the underinvestment problem stemming from friction in the labor force. They could also improve the governance of firms in the high-tech sector – all without imposing a ban on non-compete agreements.
ENDNOTES
[1] https://onlinelibrary.wiley.com/doi/epdf/10.3982/ECTA18128
[2] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2625714
[3] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4459683
[4] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3724041
[5] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4883277
[6] https://www.nber.org/system/files/working_papers/w31487/w31487.pdf
[7] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3873638
[8] https://www.gao.gov/products/gao-23-103785
[9] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=334940
[10] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1297755
[11] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4840757
[12] https://eml.berkeley.edu/~pkline/papers/KPWZ_QJE_2019.pdf
[13] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4856851
This post comes to us from Hamid Mehran, a financial economist.