Let me guess. In your venture capital or private equity firm, practically no attention is paid to nondisclosure or confidentiality agreements with prospective portfolio companies. If the form of NDA put forth by the company is relatively short, seems to have customary exclusions when defining “confidential information” and is limited in time to not more than a year, you will sign the NDA pretty much as is.
If my guess is correct, you need to read on. If I guessed wrong, you may not have to read on, but you probably will anyway because you care about what NDAs actually say. That’s the point. You should care about what NDAs say because they – like any binding contract – can bite you. And sooner or later they will.
Restrictions on Use
All NDAs obligate the fund to maintain the confidentiality of “confidential information” and to refrain from disclosing it to third parties, subject to certain narrow exceptions. That is the essence of an NDA, and that is fine. It assures the disclosing party that its confidential information will be treated with the confidentiality it deserves.
The problem – which many funds overlook – is that NDAs typically go well beyond a straightforward promise to maintain confidentiality. They now frequently contain an additional covenant to the effect that the fund will not “use the confidential information for any purpose other than evaluating a possible transaction with the company.” While seemingly innocuous, this restriction on use of information is dangerous, particularly to venture capital and private equity firms.
Let’s look at a real world example. Suppose that in an NDA with Company A, the fund agrees to keep the information confidential and further agrees not to “use” it for any purpose other than “evaluating a possible transaction with Company A.” Let’s further suppose that, after looking at Company A, the fund is not interested in the investment opportunity, leaving Company A un-funded, extremely disappointed and desperate for capital in order to compete with several other companies in the same space.
Now, what happens if the fund later invests in Company B, which is a direct competitor of Company A? Even if the fund has returned or destroyed all of Company A’s confidential information and has assiduously refrained from disclosing any confidential information to Company B, at least some of the information learned about Company A – its basic strategy, its customer churn, its access to capital, its basic financial information – is embedded in the brains of the fund managers. This adds to their overall knowledge of businesses like Companies A and B and strengthens the fund’s value to its limited partners and its portfolio companies.
Unfortunately, by assimilating information about Company A and consciously or unconsciously taking that information into account in connection with its Company B investment, the fund arguably is “using” Company A’s confidential information in direct violation of the NDA. If Company A is desperate (or angry) enough at the fund for jilting it, this type of “use” allegation could form the basis of a lawsuit seeking to enjoin the investment in Company B and/or money damages.
You may consider this type of claim to be far-fetched, but a similar line of reasoning is actually being used now in many lawsuits to prevent senior executives – even those without non-competes- from jumping ship to join competitors. The theory is that, despite the best of intentions, the executive’s head is so filled with confidential information about the prior employer that it would be literally impossible not to disclose (even unintentionally) or misuse that information in the course of working for a competitor. This “inevitable disclosure” theory is getting some traction in the courts.
Just Say No
So, what’s the lesson? Just say no to any restrictions on use, and limit your agreement to refraining from disclosing confidential information. This means that so long as you do not disclose confidential information to Company B, you should be free to use your accumulated knowledge base- including information learned from Company A- in investing in and advising Company B or any other company. An agreement to maintain confidentiality furthers Company A’s legitimate interests. Anything beyond that could provide a backdoor way to restrict the fund from investing in competitive opportunities.
Disclosure to “Representatives”
Most NDAs permit disclosures of confidential information by the fund to its “representatives,” a group often narrowly defined to include only certain “officers, directors and employees.” As a preliminary matter, the venture capital or private equity firm needs to make sure that the definition of “representatives” is sufficiently broad to capture others who are likely to be exposed to confidential information in the course of doing a deal. Depending upon the circumstances, this may include people such as attorneys, accountants, investment bankers, lenders, partners, LLC members, affiliated funds and potential co-investors.
In addition to limiting “representatives” by type of person, NDAs often provide that even disclosure to representatives is not permitted unless each representative first agrees in writing to be bound by the NDA’s confidentiality provisions. While this may be perfectly sensible from a technical and analytical standpoint, it just isn’t practical in most cases. That is, nobody but the most compulsive of fund managers is going to go around getting signatures from each and every employee, lawyer and banker involved in the deal prior to telling them anything about the deal. Impractical covenants are bound to lead to breaches, and breaches are weapons in the hands of jilted companies.
Aside from just saying no to such a requirement, there are two basic alternative solutions, neither of which is perfect. First, the NDA could be revised to permit disclosure to “representatives” who either agree to be bound by the NDA or are otherwise bound by a confidentiality obligation owed to the fund. This solution works for officers, directors, lawyers and others who have fiduciary duties to the fund but may not really adequately cover investment bankers, lenders and co-investors who do not sign separate confidentiality agreements. The second alternative is to eliminate the need for “representatives” to agree to be bound by the NDA but to have the fund be liable for any impermissible disclosure made by those who do not agree to be bound.
An NDA that restricts the fund from soliciting employees of the company for some period of time also deserves careful thought before signing. On one hand, the company understandably does not want the fund taking a pass on the investment and then promptly raiding the company’s key employees. On the other hand, giving up a right to solicit employees – a right that the fund clearly possesses prior to signing an NDA – may be a disproportionate price to pay simply for the right to be one of several funds looking at a company without any assurance that the company will pick your fund.
At a minimum, a fund should want any nonsolicitation covenant to be narrowly drafted in both time and scope. For instance, the NDA should not impair the fund from hiring employees who respond to general advertising or who approach the fund without any prompting. Also, the fund should make sure that any contractual restrictions on the fund’s right to solicit employees would not be breached in a circumstance in which a portfolio company of the fund does the soliciting on its own without the fund pulling its strings.
NDAs served up by public companies seeking private equity money nearly always contain an acknowledgement by the fund recognizing that applicable securities laws prohibit it from trading on inside information that the fund may receive in the course of its due diligence. Such provisions are perfectly appropriate and may actually serve as useful reminders to exuberant day trading fund managers.
However, some public company NDAs attempt to take more ground by seeking to impose upon the fund a contractual standstill provision that prohibits the fund from buying shares or being part of any takeover attempt for some period of time irrespective of whether any inside information is involved. The problem with this type of provision is simply that it could be a very high price to pay for a closer look at a company that could unilaterally cease the due diligence process at a moment’s notice, leaving the fund with the full burden of a standstill without having received any benefit at all.
Because NDAs are preliminary in nature and are not accompanied by money changing hands or any kind of binding commitment to invest, many venture capital and private equity investors treat them lightly. That is a mistake. NDAs are binding contracts – more binding on funds than are most term sheets or letters of intent. NDAs should be reviewed as carefully as any other formal contract that the fund is asked to sign.
Stephen O. Meredith is a Partner in the Private Equity practice group of Edwards & Angell, LLP, a 300-attorney national law firm focusing on financial services, private equity and technology. He may be reached at: email@example.com.