The Benefits and Limits of Non-Disclosure Agreements
The last few articles in the Bench to Market series discussed capital raises and licensing-out arrangements that facilitate an entrepreneur’s commercialization of a new product or process. To obtain capital or a licensing arrangement, an entrepreneur must often share a business plan and confidential information about the proposed product or process with potential investors or licensees. The entrepreneur should insist upon binding non-disclosure agreements that prohibit both the disclosure and misuse of such information, before disclosing any such valuable information.
While some inventors may hold intellectual property rights, such as patents, to protect their proprietary information, many entrepreneurs rely on trade secret protection early in the commercialization process. See our recent article, “Can You Keep a Secret?” Non-disclosure agreements are fundamental to trade secret protection, as they demonstrate that inventors have taken reasonable steps to hold their valuable proprietary information in confidence.
These agreements, however, are binding only on the parties who actually execute them. Certain venture capitalists and strategic investors may resist signing non-disclosure agreements as a policy matter or for fear that they may interfere with alternative projects or in-house development activities. Thus, entrepreneurs may need to develop “teasers” that provide basic background information on their product or process without disclosing sensitive proprietary information so that potential investors and licensees understand the benefits and burdens associated with executing a non-disclosure agreement.
To be effective, a non-disclosure agreement must identify the appropriate investor or licensee legal entities that are intended to be bound by the agreement. Those investor or licensee parties should also be responsible for breaches of the agreement by their affiliates and by any accountants, attorneys or other representatives to whom they provide information. Some non-disclosure agreements go one step further and require signers to obtain a separate non-disclosure agreement in favor of the entrepreneur from any affiliate or representative who is provided confidential information.
Non-disclosure agreements should carefully define the confidential or proprietary information subject to the agreement. If there are exceptions to the prohibitions on disclosure or use, they should be precisely and narrowly defined. Common exceptions include (1) information generally available to the public through no breach of the non-disclosure agreement, (2) information that was known by the recipient prior to disclosure by the entrepreneur, (3) information obtained by the recipient from a third party who is not bound by a confidentiality agreement or other obligation of confidentiality, and (4) information independently developed by the recipient. Exceptions (2) and (4) are subject to potential abuse by recipients; many confidentiality agreements eliminate exception (4) altogether and require that the recipient provide written evidence demonstrating the existence of prior knowledge to satisfy exception (2).
Although the main point of a non-disclosure agreement is to prohibit improper use and disclosure of the information, that prohibition is not in fact total. For example, the recipient considering an investment will “use” the proprietary information in assessing the potential investment, and so the agreement should not prohibit that use. Where an entrepreneur seeks assistance in commercializing a product or process, the use restrictions must be carefully balanced to permit necessary commercialization activities without allowing the entrepreneur’s know-how and proprietary information to become part of the public domain. Simply describing a permitted use as “commercialization” is overbroad and subject to abuse. The parties must think through the commercialization process carefully to define the circumstances under which proprietary information can be disclosed to others.
The entrepreneur also needs to think about what happens after the recipient has evaluated the confidential information provided. Agreements should permit the entrepreneur to require the return or destruction of proprietary information in a recipient’s possession at the entrepreneur’s request. But the return or destruction of documents may not be enough, since the recipient of the information still knows it. To cover that issue, the agreement should require recipients to maintain the confidentiality of such information for a lengthy or indefinite term.
What happens if the recipient violates the prohibitions in the agreement and, for example, discloses the information to another party? The usual legal remedy for breach of an agreement is to sue for money damages. But in a case such as this, it could be impossible to determine what the damages are—how can one value the potential value of proprietary information that could be a bonanza or could be a bust? The alternative is to provide an acknowledgment by the parties that breaches of the agreement cannot be cured by monetary damages alone, and that equitable remedies such as temporary restraining orders and injunctions are appropriate to restrain breaches. Then, if the recipient is breaching the agreement, the inventor can go into court and obtain a court order that will stop the recipient in his tracks. Some people may violate their agreements, but they will think long and hard before violating an order from a court.
Entrepreneurs should also consider whether to include a covenant that prohibits solicitation of employees, sometimes called a “no-poaching covenant.” Potential investors who gain access to start-up businesses may decide to pass on an investment but to offer employment to talented employees with whom they interact during due diligence. A tailored employee non-solicitation provision will protect the entrepreneur from employee raiding.
Confidentiality agreements are generally a precursor to more definitive investment or licensing agreements entered into after due diligence has been completed and a plan for commercialization has been developed. Entrepreneurs generally seek to include in these preliminary agreements language that disclaims any representations and warranties with respect to the proprietary information to be disclosed during due diligence. Such representations are warranties are more appropriate in the context of definitive agreements when the business arrangements and related representations and indemnities can be spelled out in detail.
While well-crafted non-disclosure agreements provide entrepreneurs with legal and equitable remedies for improper disclosure or use of proprietary information, the agreements alone may not be effective to stop “bad actors” from potentially harmful disclosures. Therefore, entrepreneurs need to undertake their own diligence about potential recipients of proprietary information to confirm that such persons are professional and respected participants in the marketplace.