Non-disclosure agreements (“NDAs”) are possibly the most misunderstood category of legal documents. To some, they are boilerplate forms that you can download from the Internet and use with little to no revision needed. To others, they are intimidating and overwhelming due to the complicated legalese they contain. Some believe an NDA should be required prior to almost any business discussion with anyone. Others believe NDAs are unenforceable (or at best impractical to enforce) and reject their usefulness altogether. Who’s right?
As is the case so often in the law, the correct answer is “it depends”. NDAs can, without question, be an invaluable tool for entrepreneurs and businesses in certain situations. Used improperly, however, NDAs may do more harm than good. In this article I try to cover the basics.
First, what exactly is an NDA? An NDA is an agreement between two or more parties in which certain restrictions are imposed on the disclosure of confidential, proprietary, or secret information. Sometimes only one party is (or some number less than all of the parties are) going to share confidential information; these are typically referred to as “unilateral NDAs” because the confidential information is only flowing one way and the obligation to protect and keep secret that information is flowing the other way. In other words, in a unilateral NDA, the confidential information is being disclosed in exchange for a promise to keep that information confidential.
On the other hand, sometimes both (or all) parties intend to disclose confidential information to each other. In those cases, a “mutual NDA” is appropriate because all parties are agreeing to disclose (or at least possibly disclose) confidential information and all parties are agreeing to respect the confidential nature of the other party’s information and not disclose it. In either case (unilateral or mutual NDA) the purpose of entering into this type of agreement is to encourage the free flow of information, typically in contemplation of the parties evaluating or conducting some kind of business transaction. In exchange for the privilege of being allowed access to certain information, the receiving party is bound by the NDA to not disclose that information.
There are certain situations in which an NDA is almost always appropriate. I have listed some of them below:
Seeking Investors in a New Product, Venture or Service:
Imagine you have invented a new product that will be revolutionary, but you need an outside investor to help fund the multiple steps in the commercialization process to get the product to market. You may also want to approach some existing companies that are already operating in the commercial space your invention will occupy. To attract the investor’s and the company’s interest, you must disclose to them certain secret proprietary information about the product. (Examples may include secret formulas, materials or ingredients, etc.) Before disclosing this type of information, it is standard practice to have the investor or the company sign an NDA to ensure that no matter what happens during your discussions, they will not steal your proprietary information.
There may in some cases be a few problems with this line of thinking. First, almost every inventor believes his new product is revolutionary, and in reality almost in every case it is not. In fact, it is entirely possible that whoever you are pitching to has seen something similar or identical to your idea before. The verse from Ecclesiastes “What has been will be again, what has been done will be done again; there is nothing new under the sun” is never more true than when applied to inventors. This is one reason why investors (and even moreso, companies) are reluctant to sign NDAs. They may have already heard of (or even be working on) an idea identical or similar to yours. By signing your NDA, they are inviting you to sue them when you find out they’re working on your idea, even though your idea didn’t come to them from you. Most people, even investors and big companies, don’t like to deal with the nuisance of a lawsuit, and are therefore often unwilling to sign your NDA.
Second, no matter how great your idea might be, virtually no investor is interested in stealing it. If you don’t believe me, try this experiment. Take your very best idea and disclose it for free without asking anything in return to the ten richest investors you can find. Then come back and let me know how many of them took your revolutionary idea and attempted to commercialize it. I assure you the answer will be zero.
Third, even if an investor wanted to steal your revolutionary idea, it’s highly unlikely they’d be able to execute on it. Unless the potential investor is a competitor of yours or is operating in the same or a similar commercial space as you, the practical obstacles to them stealing your idea and being able to bring it to market themselves or even with help are very high. For these reasons, requiring an investor to sign an NDA in order to be granted the privilege of hearing your pitch often is an unreasonable thing to ask or expect.
Maintaining a Trade Secret:
Trade secrets such as formulas, client lists, algorithms, and the like, are trade secrets in large part because they are kept secret. Since secrecy is essential to their existence, it is always a good idea to limit access to them. The problem is that some people need to have access to this information, including employees and sometimes even outside contractors or third parties. Your proprietary formula blend being made by your manufacturer (whether down the road or across the country) can only happen if they have your secret recipe. In this situation, it is usually a very good idea to have the parties who have access to the information sign a non-disclosure agreement to maintain the legal protections afforded under trade secret laws.
Here again, however, there are exceptions. For example, you could have one manufacturer create part of your secret recipe, and another manufacturer create another part. Then a third manufacturer could combine the two parts to create the final product. Under this scenario, no single third party has access to all of your confidential information.
Entering into Joint Ventures:
Businesses often consider joining together for a particular project or effort, and in doing so must disclose some amount of proprietary information to the other in order to evaluate the deal and make the venture a success. Again, this is a typical situation where a non-disclosure agreement is a good idea not only to ensure that the information remains confidential, but also to set the rules for how that information will be used by both companies during the venture.
As with the other examples above, there are exceptions here too. One common structure for a joint venture is to form a new legal entity that is partly owned by each JV partner. In that situation, it may be possible for one or both parties to contribute confidential information to the new JV entity as part of the deal terms. In this situation you still may want some confidentiality terms baked into your operating agreement or shareholders agreement, but there may not always be a need (especially at first) for a standalone NDA.
To prevent unauthorized disclosure of information by employees:
In some cases, sensitive information is obtained and processed by employees of the business. In these situations, it can be beneficial to have employees sign NDAs preventing them from disclosing information about the company and its customers. In some cases there may be state or federal laws in place that already prohibit such disclosures.
As you can see, there are a variety of situations in which an NDA might be appropriate. Hopefully you can infer from what I have written above that NDAs are not “one size fits all” documents and there is no NDA that will work in every scenario. I have personally been involved in situations where parties mistakenly thought their confidential information was protected, only to find out that the language of their NDA didn’t provide the scope of protection they expected.
Business owners and entrepreneurs should consider when in the lifecycle of their venture an NDA is appropriate. When an NDA is needed, make sure it contains customized protections that accomplish your goals. If you have questions about NDAs for your business, contact me at chris@chrisclark.law for more information and to discuss your situation.
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