Innovation Strategies Against Knowledge Leakage: Externality Effects of Non-competes Enforcement

Abstract

We examine how firms innovate and strategically respond to a potential threat of knowledge leakage. In 1998, the California Court of Appeal ruled that non-compete agreements (“non-competes”) are void in California, even if they are written between an out- of-state employer and employee. This decision suddenly created a loophole for non-California firms in their enforcement of non- competes, since their workers who signed non-competes could move to firms in California. We find significant externality effects of this decision on firm strategies on innovation and knowledge protection. Firms increase patenting activities primarily for protective reasons (without increasing R&D inputs). Firms also change the scope of innovation by engaging more in firm-specific technologies in order to reduce misappropriation risks. The California-driven loophole also changed firm external relations. Firms decrease their collaboration with firms in California, in fear of employee and knowledge leakage. In M&As, on the other hand, firms favor targets in California than those outside California to reap gains from hiring freedoms.