Avoid Three Common Pitfalls In Your Next NDA

If you run a company, you have probably had many requests from a potential business partner to sign a non-disclosure agreement (NDA). The NDA may be a short document, containing what appears to be just a few pages of legal boilerplate, and the other party may assure you that this is their “standard” form. While a typical NDA may look innocuous enough, you shouldn’t assume that it will give complete protection to the sensitive information you may be revealing, and the NDA may restrict you in ways you didn’t expect. This article describes some terms that companies should be on the lookout for when asked to sign an NDA.

  • “Residuals” clauses. While NDAs typically contain a broad restriction on use of the other side’s confidential information, an NDA will sometimes contain a “residuals” clause that allows a party to use information that its personnel retain in their unaided memory. By allowing the use of data retained in this manner, a “residuals” clause can undermine the basic protections of the NDA.
  • Is the existence of the NDA itself a secret? Sometimes an NDA will provide that the existence of the NDA itself constitutes confidential information that cannot be disclosed. For example, a high-profile company may not want an early-stage company broadcasting that the two companies are exploring a possible partnership. This restriction can place a company in an awkward “catch-22” if it is required to disclose its NDAs to a potential investor or acquirer as part of a diligence process or in a disclosure schedule; the company may have to choose between breaching the NDA in order to disclose it, or failing to comply with the diligence requests or disclosure obligations with respect to a potential investor or acquirer.
  • The “mutual” NDA that really isn’t. A potential business partner may ask you to sign its standard form of NDA, which will be titled as a “mutual” NDA. While most of the provisions may in fact apply to both sides equally, a close read often reveals some one-sided provisions in favor of the company that drafted the NDA. For example, they may allow themselves to retain a copy of your confidential information for their records, or impose asymmetrical restrictions on your use of their confidential information. A company should not assume that a “mutual” NDA is completely even-handed, and should be alert for terms that just apply to one party.

 


Aaron B. Sokoloff

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Aaron’s practice focuses on corporate law, including startup/venture capital and mergers and acquisitions. Aaron has represented venture-backed companies in early- and late-stage equity financings as well as debt financings. He has experience representing both buyers and sellers in M&A transactions.

For additional information, please contact:

Aaron B. Sokoloff

Procopio, Cory, Hargreaves & Savitch LLP

12544 High Bluff Drive, Suite 300, San Diego CA 92130

Direct Dial: (619) 906.5739

Email: aaron.sokoloff@procopio.com

What Startups Can Do Now to Avoid Due Diligence Problems

The time between signing a term sheet and closing a financing can be an incredibly intense period for a startup. As part of the financing process, the company will typically have to provide copies of a wide range of company documents to the investor’s lawyers for due diligence review. The more prepared the company is for this process, the more quickly the diligence review is likely to go, allowing the company to get to closing faster. Companies that are unprepared for diligence must often involve their lawyers more closely in the process; thus, being prepared for diligence can help a startup control its legal costs. Furthermore, if a company is prepared for diligence, this helps give the investor and its lawyers confidence that the company is organized and well-run. Conversely, when investor counsel asks for diligence materials and finds them to be incomplete or inadequate, they start to wonder what else the company is doing wrong, and may become more aggressive in their diligence review. Here are three simple things that startups can do on a day-to-day basis in order to be prepared for the legal diligence process in their next financing. While these may seem mundane, paying attention to these items as you go can help keep legal diligence from delaying or derailing the financing.

  • Contracts. Investor counsel will typically need to review the company’s major contracts, such as intellectual property license agreements, office leases, and any major customer agreements. Very often, startups need to scramble to assemble these when the diligence request arrives. They may have copies of contracts that are signed by one party but not the other, or that are otherwise incomplete. Keeping complete, fully signed copies of any contracts that are important to the business in one place, ideally in PDF or similar format, will allow the company to respond to this category of diligence request quickly and efficiently.
  • Invention Assignment Agreements. Investor counsel will typically want to confirm that all of the company’s employees and contractors (or, at the very least, all employees and contractors that have contributed to the company’s technology) have validly assigned their relevant inventions to the company. This is one of the key diligence items for investors in technology companies, because gaps in invention assignment agreements may mean that the company does not legally own the technology that drives the company’s value. Chasing down invention assignment agreements can quickly become a nightmare, especially if the contributors are no longer employed with the company; these contributors may perceive that they have their former company in a “hold-up” situation and may demand concessions in order to sign over their inventions. For this reason, companies should be diligent about having employees and contractors sign invention assignment agreements when they start with the company, and keeping the signed agreements on file in an easily accessible place.
  • Option Records. Investor counsel will sometimes want to review each of the company’s option agreements to make sure the agreements match the capitalization records. The option agreements are important not only for diligence purposes in financings, but in determining equity ownership upon a sale of the company. The company should therefore keep signed copies of all of its option agreements on file.

AARON B. SOKOLOFF

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Aaron’s practice focuses on corporate law, including startup/venture capital and mergers and acquisitions. Aaron has represented venture-backed companies in early- and late-stage equity financings as well as debt financings. He has experience representing both buyers and sellers in M&A transactions.

For additional information, please contact Aaron directly:

Procopio, Cory, Hargreaves & Savitch LLP

12544 High Bluff Drive, Suite 300, San Diego CA 92130

Direct Dial: (619) 906.5739

Email: aaron.sokoloff@procopio.com

The Trouble with Strategic Financings

While early stage technology companies typically seek investment from angels and VCs, strategic investments from commercial partners can also be a valuable source of capital. Strategic investors can often offer higher pre-money valuations than angels or VCs since they may be gaining in other ways from the relationship. In addition, if the capital investment is intelligently combined with a commercial agreement, the overall result may be greater than the sum of its parts. Despite the potential advantages of such financings, however, negotiating the financing and commercial arrangements together results in a unique set of issues, and startups should be aware of these before embarking on a strategic financing:

Increased Complexity; Importance of Understanding Commercial Terms. Adding a commercial agreement to a financing transaction can add disproportionately to amount of time and expense that will be needed to get to closing. The legal documents for early-stage equity investments are often based on well-known forms; lawyers that are experienced in early stage financings can provide specific guidance on deal terms. Commercial agreements, on the other hand, often require the business principals to become more directly involved in the negotiations, since their terms are driven much more by the day-to-day realities of the company’s business. The company’s management should therefore realize it will likely have to put significantly more time and effort into hashing out deal terms than in a pure financing transaction. If the company’s lawyers are involved in negotiating the commercial agreement in addition to the investment documents, the legal fees may also be significantly higher than in a VC or angel financing. Some of the requested terms, since not financial in nature, often go to the heart of what creates value in the business and, therefore, if not carefully considered and negotiated, can result in a reduced value of the company after the financing. For example, it is not uncommon for strategic investors to ask for an exclusive relationship of some sort (whether as an exclusive provider or re-seller of the company’s products or services), and companies should carefully consider the foregone opportunities. Some strategic investors also insist on special access to intellectual property rights, or on covenants not to sue, which can chill future acquisitions.

Different Incentives. When an angel or VC makes an investment in a company, their ultimate goal is fairly clear: to get a strong financial return on the investment. When a commercial partner makes a strategic investment, they are likely to be motivated by a combination of financial returns on the company’s stock and the commercial relationship. The multifaceted goals of strategic investors can ultimately bring them into conflict with the founders in ways that would not happen with VCs or angels. For example, if the company later receives an offer to be acquired by a competitor of the strategic investor at a high valuation, the founders and financial investors may want to take the deal, but a strategic investor may want to prevent it, even if it stood to receive a significant return on its investment in the acquisition. The company will need to keep these dual motives in mind in a strategic financing, especially when it comes to negotiating provisions that govern future financings or a sale of the company.

While teaming up with one of the major players in a company’s space can seem like a very good idea, and may create more value than could be expected from an angel or VC investor, care needs to be taken to avoid pitfalls common to these relationships, including the possibility the relationship with the new partner deteriorates, with that partner having disproportionate leverage.


PAUL B. JOHNSON

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Paul is Co-chair of the firm’s Mergers & Acquisitions and Strategic Join Ventures practice group. His practice focuses on buy and sell-side mergers and acquisitions, venture capital investments, securities offerings and compliance, startup companies and general business counseling.

For additional information, please contact Paul directly:

Procopio, Cory, Hargreaves & Savitch LLP

12544 High Bluff Drive, Suite 300, San Diego CA 92130

Direct Dial: (619) 525.3866

Email: paul.johnson@procopio.com

 

AARON B. SOKOLOFF

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Aaron’s practice focuses on corporate law, including startup/venture capital and mergers and acquisitions. Aaron has represented venture-backed companies in early- and late-stage equity financings as well as debt financings. He has experience representing both buyers and sellers in M&A transactions.

For additional information, please contact Aaron directly:

Procopio, Cory, Hargreaves & Savitch LLP

12544 High Bluff Drive, Suite 300, San Diego CA 92130

Direct Dial: (619) 906.5739

Email: aaron.sokoloff@procopio.com