Client-Based Entrepreneurship

rauch, james e. ; watson, joel;

Client relationships create value, which employees may try to wrest from their
employers by establishing their own firms. If an employer and worker cannot
contract on the output and profits of the worker�s prospective new firm, at the
beginning of their relationship the employer induces the worker to sign a contract
that prohibits him from competing or soliciting the current client in the event
of termination of employment. The socially optimal level of entrepreneurship will
nevertheless be achieved if clients, employers, and workers can renegotiate
these restrictive employment contracts and make compensating transfers.
If workers cannot finance transfers to employers, however, employers and
workers will sign contracts that are too restrictive and produce too little entrepreneurship, and governments can increase welfare by limiting enforcement of
these contracts. With or without liquidity constraints, locations where noncompete
contracts are less enforced will attract more clients and have higher employment and output