19 Jul Secrets to a Well-Drafted Nondisclosure Agreement
Whether the sale of your business kicks off with you contacting a prospective buyer or a prospective buyer contacting you, you can’t disclose much about your business without having a good nondisclosure agreement in place. Otherwise, you’ll risk exposing to the public, and potential competitors, sensitive information that could be used to harm your business. Think about your customer list ending up in the hands of a competitor or of word spreading to your employees that a new owner is going to take over. The consequences could be devastating. All too often business owners assume that a nondisclosure agreement is a form document, with one form as good as another. So they find a short agreement on the internet, change the names and sign. The business owner breathes easier, confident that their proprietary secrets will be preserved. It’s only when trouble arises that these business owners learn the secrets to a well-drafted nondisclosure agreement.
A nondisclosure agreement, also called a confidentiality agreement, is ordinarily the first legal document you will need when selling your business and it can set the tone for the remainder of the transaction so it is important to get a good one in place early in the process. Typically, buyers want to review some of your business information before making a formal offer. This includes company tax returns, financial statements, customer lists and operating manuals. Before you send these items off to the buyer, hit the pause button for a minute. If you don’t have an attorney yet, now is the time to get one. A good transaction attorney will urge you to get a good nondisclosure agreement in place. Ideally, you will use the form provided by your attorney but if the buyer is proposing his own form, your attorney will point out the strengths and weaknesses and recommend revisions if needed. There are often a number of provisions in a nondisclosure agreement where a minor modification to the language can result in a major change to the meaning. Below are a few key areas to make sure you understand before signing:
- Definition of Confidential Information: While the definition of “confidential information” can appear fairly standard, you will need to make sure it is not too limited. You will generally want it to cover all information you furnish to the prospective buyer, regardless of if marked confidential and regardless of form. This creates a default presumption that if you delivered the information, it is confidential information and covered by the nondisclosure agreement. The definition should also cover as confidential the fact that discussions around a proposed transaction are taking place. Even if the prospective buyer keeps your documents confidential, you do not want them letting others in the market place know that you are considering selling your business.
- Time Frame: You should start with the position that the restrictions on use and disclosure are perpetual and never expire. However, in the marketplace, most private equity buyers will try to negotiate a term for the nondisclosure agreement causing it to expire after a certain number of years. In those cases, it is important that you agree to a term that is adequate to protect your information and that the buyer is obligated to return or destroy any confidential information (including copies) at the end of the term. This means that by the time the term ends, the information you provided will be stale and that the buyer should no longer have access to such information. If your business has specific trade secrets that need to be covered indefinitely, they can be carved out to survive for so long as the trade secret protection remains in effect.
- Representatives: Nondisclosure agreements often contain a provision that allows the prospective buyer to share certain information with its “Representatives” which includes certain officers, directors, employees and even third-parties such as attorneys, CPAs or financing sources. The prospective buyer will likely require some level of sharing to ensure they can appropriately analyze the opportunity while you, on the other hand, are seeking to limit the universe of people that will end up with your confidential information. A well-drafted NDA should limit the term “representatives” to only those people who are required to receive such information for purposes of analyzing the transaction and also require that the prospective buyer be jointly and severally responsible for disclosure of confidential information by one of the representatives. In other words, the provision on representatives should cut both ways; to the extent the prospective buyer wishes to share information with other parties, the prospective buyer should be responsible for any breach by those parties.
- Non-Solicitation: Of particular importance when the prospective buyer is in the same industry is the non-solicitation provision. In addition to keeping information confidential, prospective buyers should be prohibited from poaching your employees and independent contractors. Further, you will need to consider if this non-solicit should extend beyond employees and also be a non-solicitation of business relationships. Given the competitive nature of the two parties, this may be a necessary protection for you as a seller while the buyer will be reluctant to agree for fear it will inadvertently restrict their current business. Regardless of the results of the non-solicitation negotiations, you should consider a tiered release of information. You may provide basic financial information or redacted records and engage in a few preliminary discussion to determine if there is bona fide interest before you release more sensitive information.
Sometimes, however, they are blessed with market information or have recently received a bona fide offer for the business so they have a good idea of what it would sell for. In these cases, designating the value might make sense but values change and the biggest drawback to designating the value is that once a value is set, small business owners almost always neglect to update the value. I’ve see companies in which the shareholders were so busy running the company that they hadn’t updated the valuation in fifteen years. So, when a shareholder suddenly dies, the value of the business according to the buy-sell agreement is $500,000 when in fact the business is worth $3,000,000. And even if you remember to update the valuation, don’t assume your fellow shareholders will agree to a new value. Most agreements require unanimous consent to designate value and one uncooperative shareholder can make it impossible to update the value.
In addition to these provisions, you should review the restrictions on use and disclosure and the provisions regarding the return or destruction of materials and the consequences and enforcement issues. Finally, pause and revisit the potential consequences and enforcement issues. Ask yourself one final time if you are ready to share your sensitive information with the other party. The reality is that even with a good nondisclosure agreement in place it can be difficult to prove the other party has breached the agreement and used your confidential information. Make sure the other party is trustworthy and diligent in their dealings.
We have reviewed and negotiated hundreds, if not thousands, of nondisclosure agreements on behalf of both buyers and sellers. We firmly believe an efficient review and understanding of the agreement is well worth your time and that a well-drafted agreement puts you in control of the transaction. Most importantly, a well-drafted nondisclosure agreement protects the value you have created in your business and gives you the confidence to move forward with negotiating the sale of your business.