FRBSF Economic Letter
2002-24; August 16, 2002
On the Move: California Employment Law and High-Tech Development
Regional Report.
The Regional Report appears on an occasional basis. It is prepared under
the auspices of the Financial and Regional Analysis Section of the FRBSF's
Economic Research Department.
With the high-tech sector still mired in a slump, critical questions
include where the industry will head next, and what role Silicon Valley
will play in future waves of tech innovation and investment. The Internet
and tech investment bust left many failed firms and thousands of unemployed
workers in its wake in the Valley. Yet this area has reinvented and reinvigorated
itself before—for example, after the surge in competition from foreign
semiconductor makers in the mid-1980s—and is likely to do so again. Silicon
Valley's competitive edge in tech development and marketing has been linked
to several factors, including the active role of local universities and
research centers and a unique set of venture capital firms. Some observers
also have pointed to a business culture that provides an unusual degree
of support for employee mobility and entrepreneurship, thereby spurring
innovation through the rapid diffusion of the tech knowledge base. In
this Economic Letter, I discuss the role of employee mobility and knowledge
transfer in the development of tech centers, and I describe an underlying
feature of employment law that may help support tech innovation in California
and a few other states.
Employee mobility
One oft-cited aspect of Silicon Valley is rapid turnover among skilled
employees and entrepreneurs (Saxenian 1994). In some industries, on-the-job
skills specific to a particular firm lead to human resource practices
that encourage long-term jobs. In other industries, essential skills and
knowledge are more general, pertaining to the industry as a whole rather
than to a specific firm. Under such circumstances, frequent job mobility
can increase the pace of technological change and product innovation through
the rapid dissemination of ideas and knowledge. The term "high-velocity
labor market" was coined by Hyde (1998) to describe a regional labor
market where skilled employees switch firms frequently, bringing valuable
skills with them to existing firms and spinoffs alike, functioning as
entrepreneurs in some cases and as essential development staff in others.
The rapid dissemination and cross-fertilization of innovative ideas such
mobility affords likely offers collective advantages to the industry as
a whole in a rapidly changing environment, since the spread of some ideas
is essential to their successful development.
Saxenian contrasts Silicon Valley with the Route 128 corridor near Boston,
which she describes as dominated by more traditional, vertically integrated
companies. Route 128 firms tend towards well-defined hierarchies and internal
promotion ladders, networks that look inward rather than outward, and
attitudes about company loyalty and business failure that suppress worker
mobility and risk-taking. In this environment, job-hopping is discouraged,
and spinoff activity does not occur at Silicon Valley's dizzying speeds.
While this alternative model offers its own advantages, especially for
sustained research and development, it may offer disadvantages when product
development is fast-paced.
Direct evidence on the relative extent to which Silicon Valley is characterized
by rapid employee turnover and knowledge transference is limited. Saxenian
(1994, pp. 30-37) relies largely on anecdotal evidence based on interviews
with executives from Silicon Valley and Route 128, many of whom worked
in both regions during their careers. In addition, using a sample of 275
semiconductor industry engineers for the late 1980s, Angel (1989) found
statistically significant evidence of higher turnover among those who
work in Silicon Valley, compared with the rest of the country. Although
not definitive, the available evidence suggests that the Silicon Valley
labor market operates differently from other high-tech labor markets.
This apparent difference between Silicon Valley and Route 128, and the
areas' divergent development paths in the 1980s and 1990s, have been explained
as the outgrowth of cultural differences that emanate from Route 128 executives'
traditional approach to business, which contrasts with the more open minded,
"pioneer" attitudes in California. But relying on cultural differences
as an explanation begs the question of what underlies them. Moreover,
no matter what business culture prevails, firms in general prefer not
to lose valued employees to competitors and often act to prevent employee
defections, through legal channels or other means. This occurs in Silicon
Valley as well as elsewhere. Yet tech firms in Silicon Valley appear to
have a culture that encourages employee mobility, which may increase the
region's innovative capacity but sometimes works against individual firm
interests. Why?
The legal status of "covenants not to
compete"
One potential explanation for Silicon Valley's culture of employee mobility,
which only recently has been identified by legal scholars, rests on elements
of California employment law that developed largely through historical
accident (Gilson 1999). In particular, Section 16600 of the California
Business and Professions Code specifies that "every contract by which
anyone is restrained from engaging in a lawful profession, trade or business
of any kind is to that extent void." The direct precursor to this
law dates to 1872, when idiosyncratic historical circumstances contributed
to the passage of a newly designed, comprehensive civil code by the California
legislature. The California courts have consistently interpreted Section
16600 as a prohibition against "covenants not to compete." These
are clauses in written employment contracts specifying that after employment
termination individual employees may not work for competitors in a specified
geographic region corresponding to the employer's market. Most other states
allow such covenants if the geographic scope and duration of the prohibition
is "reasonable"; the definition of "reasonable" has
developed through court proceedings based on employee or employer lawsuits.
California's ban on covenants not to compete gives departing workers
substantial latitude to share critical ideas and knowledge with existing
firms or spinoffs. Because this law predates the founding of modern technology
industries in California, it probably contributed to the evolution of
Silicon Valley's culture of employee mobility. As the Valley developed,
court cases highlighted and reinforced limits on employers' ability to
restrain the dissemination of their former employees' intellectual capital
(see Hyde 1998 for two examples). Of course, departing workers are not
allowed to reveal specific trade secrets. In this regard, California law
is similar to that in most other states, under the Uniform Trade Secrets
Act; in fact, California law provides somewhat broader trade secret protection
than the model act (Gilson 1999). However, for workers with general industry
knowledge, mobility in California is largely unrestrained.
Recent tech growth
A comparison of tech growth across states illustrates the potential role
of the legal climate for employee mobility. I focus on states because
the relevant employment laws are defined at the state level. For this
exercise, I compare the growth record in the broad tech sector as defined
by the American Electronics Association (AEA 2001) with growth in its
computer services sub-sector, which includes, among other enterprises,
software makers and Internet companies. The computer services sector was
characterized by high growth and rapid innovation between 1995 and 2000,
market characteristics that may be enhanced by a legal climate that supports
the transference of intellectual capital across competing firms. By standardizing
based on overall tech growth, thereby accounting for factors that affect
tech growth in general, the comparison between the sectors provides a
more informative test of the role of the legal climate than would an examination
of either sector alone. To focus attention on states with highly developed
tech sectors, the tabulations are provided for the 15 states with the
greatest overall tech employment density in the year 2000 (similar results
are obtained when all states are used). Among these states, California
and Colorado have state laws and relevant judicial interpretation that
ban covenants not to compete in employment agreements. By contrast, each
of the other states' laws allows for covenants not to compete under general
restrictions on scope and duration (Filipp 2001). North Dakota is the
only other state in which both the law and judicial interpretation effectively
ban covenants not to compete (Hyde 1998, Filipp 2001), but its tech sector
is too small for inclusion.
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Figures 1 and 2 display average yearly growth rates for employment and
annual salaries in the computer services and broad tech sectors during
1995-2000. The growth rates for each state are indicated by the points,
and the lines represent the least-squares fits for these points. States
lying above the lines experienced relatively rapid growth in computer
services employment or salaries, given the average relationship between
growth in computer services and broad tech. In Figure 1, California and
Colorado are among the few states that lie above the line and therefore
are outliers with respect to employment growth in computer services. For
these two states, unusually rapid growth in computer services employment
likely is linked to a legal environment that supports the transference
of intellectual capital across competing firms. Arizona and New Hampshire
also are outliers with respect to relative employment growth in computer
services. However, broad tech growth was not very rapid in these states;
an unfavorable legal climate for employee mobility may play a role in
this regard, by limiting the pace of growth in innovative sectors other
than computer services. Moreover, Figure 2 shows that growth in annual
salaries, which reflects value per employee—an important measure of industry
performance—was not as rapid in Arizona and New Hampshire as it was in
California and Colorado. The slope of the fitted line and close clustering
of points around it in Figure 2 indicate that tech labor markets are not
highly segmented, in the sense that tech employees within a state faced
relatively uniform rates of salary increases across sub-sectors.
Of course, other factors besides employment law affect employment and
salary growth in tech sectors. For example, Washington state stands out
as a high performer, largely due to idiosyncratic factors that underlie
Microsoft's decision to locate in the Seattle area. And in California
and Colorado rapid tech growth is related in part to the pre-existing
density of broad tech activities in the base year (1995). However, the
base year density in those states in turn may reflect the prior impact
of rapid employee and entrepreneurial mobility. Overall, although these
comparisons are not comprehensive, they suggest that employment laws favorable
to transference of employees' intellectual capital may play an important
role in the development of rapidly innovating tech sectors.
Implications
This discussion suggests that Silicon Valley's success may derive in
part from some unique features of California employment law. Like all
states, California law does not protect employees who reveal trade secrets.
However, for more general forms of industry knowledge, California's legal
ban on covenants not to compete may enhance the dissemination of knowledge
and ideas through rapid employee and entrepreneurial mobility. This system
of law shaped Silicon Valley over a long period, and as such cannot be
simply imposed on other regions as a means of enhancing regional tech
development. Moreover, these arguments should not be construed as minimizing
the vitality and innovative drive of other regions, or the value of development
and innovation that occurs under the auspices of a single worker or team
working for a single employer for a sustained period. But in regard to
some products whose development benefits from the rapid cross-fertilization
of ideas, states like California and perhaps Colorado, whose laws support
mobility of intellectual capital, may have an edge.
Rob Valletta
Research Advisor
References
American Electronics Association. 2001. Cyberstates 2001. Washington,
DC.
Angel, David P. 1989. "The Labor Market for Engineers in the U.S.
Semiconductor Industry." Economic Geography 65(2, April),
pp. 99-112.
Filipp, Mark R. 2001. 2001 Cumulative Supplement to Decker, Kurt
H., Covenants Not to Compete, 2nd ed. New York: John Wiley &
Sons.
Gilson, Ronald J. 1999. "The Legal Infrastructure of High Technology
Industrial Districts: Silicon Valley, Route 128, and Covenants Not to
Compete." New York University Law Review 74(3), pp. 575-629.
Hyde, Alan. 1998. "Silicon Valley's High-Velocity Labor Market."
Journal of Applied Corporate Finance 11(2), pp. 28-37.
Saxenian, AnnaLee. 1994. Regional Advantage: Culture and Competition
in Silicon Valley and Route 128. Cambridge, MA: Harvard University
Press.
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