The Fact and Fiction of Non-Disclosure Agreements

by Foley & Lardner LLP
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Entrepreneurs looking for angel or venture funding, or a strategic partnership, rely on Non-Disclosure Agreements, or NDAs, to protect their trade secrets, shield employees from poaching by the other parties, and keep financial information confidential. By now, just about every entrepreneur knows that an NDA is critical. Most also understand that a party receiving confidential or trade secret information who signs an NDA is contractually obligated to keep that information protected, and not to use it in her own business. A bit more subtle, but equally important, point is that only through a rigorous process of collecting NDAs from everyone to whom trade secrets are disclosed can the entrepreneur retain her intellectual property rights in those trade secrets. To put it another way: if the entrepreneur discloses her trade secret to some people without an NDA (she “publishes” it), that information may lose its trade secret protection altogether.

Here is an example of the latter point. You and your friends are hanging out at a bar one night after work, and over beer you hear one of your friends tell the others about the product she is developing or some challenges in converting a technical idea into a tangible product – in the meantime revealing some trade secrets about the product. If some person overhears that conversation, or otherwise finds out the substance of the trade secrets that you were discussing, he can claim that those trade secrets are no longer protected: all of your friends were discussing them without having signed NDAs.

There is an exception to this written NDA requirement – one most often invoked by venture capitalists who generally refuse to sign NDAs. This exception is called the “expectation of confidentiality.” A trade secret disclosed to someone who routinely receives trade secrets and does so with a clear (if oral) understanding that she will keep those trade secrets confidential will not trigger the “publishing” exception. Nonetheless, there is no assurance that a person who receives trade secrets under an expectation of confidentiality will honor that obligation – other than the personal qualities and reputation of the recipient.

NDAs are certainly not a foolproof shield against a dishonest partner. Recently, one of my emerging company clients with a truly disruptive idea and a great management team, found this out the hard way. They had been talking to a Fortune 100 company using that company’s “standard” NDA. After months of effort and collaboration, my client was ready to introduce its product at a customer conference sponsored by the Fortune 100 corporate partner. Instead, the partner introduced its own product, using my client’s trade secrets. That presented a fundamental flaw of NDAs: in order to enforce the NDA, my client would have to sue the infringing party. And how many early stage businesses can afford to bring a lawsuit against a Fortune 100 company? Any such lawsuit, especially one alleging unscrupulous behavior on the part of the large company, would draw a quick and very expensive countersuit.

Is there a lesson here?

Certainly, securing an NDA is critical. However, equally critical is the text of the NDA itself. NDAs presented by the other party, or pulled from the web, often have gaping holes in them – either intentional or not.

At times, it’s not the NDA that is at fault, but the disclosing party’s failure to follow the procedures required by the NDA. Many NDAs specify that materials discussed or exchanged must be marked confidential and oral discussions of trade secrets must be confirmed in writing. Often, these procedures are not followed and, as a result, information intended to be confidential becomes freely available to the receiving party.

There is also the “steak and sizzle” rule: show only the sizzle – the non-confidential, non-trade secret opportunities presented by your idea – to the other party, and keep the “steak” – the core intellectual property – to yourself.

Entrepreneurs and investors are often anxious to tell everyone about their invention. My suggestion is to be very judicious in limiting disclosure to only those with a strict “need to know.”

Finally, there is the smell test: do you trust the party you’re dealing with? What is its reputation in the community? Is that party asking suspicious questions indicating some hidden agenda?

Disclosing key intellectual property to a third party always carries a risk, NDA or no NDA. All you can do is assess and reduce that risk through your actions, being continually aware that relying on an NDA is not sufficient.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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