Delaware Decision Highlights Dilemma for Startups to Protect Their Trade Secrets When They Seek Investment Financing

Counsel advising businesses must often deal with conflicting goals; that is especially true for startups. Such businesses want to protect their intellectual property (including trade secrets) but still be able to disclose enough to attract investment capital. A recent Delaware decision highlights the tension in these goals.

All businesses want to protect their intellectual property, including their trade secrets and other confidential information. On the other hand, since intellectual property is often a startup’s chief asset, startups need to share their information with investors to convince them of the value of what they have developed. The standard response is to use a non-disclosure agreement. But those have their limits – investors often insist on flexibility to invest in other companies, including competitors.

A recent Delaware Chancery case, Alarm.com Holding, Inc. v. ABS Capital Partners Inc. (2018), highlights this tension. The court dismissed a trade secret complaint by a technology company against an investment company because the only basis for the claim of misappropriation of trade secrets was the move to the competing firm – which had been expressly agreed was allowed.

Counsel advising startups and drafting NDAs need to be aware of this tension. Startups often lack the negotiation leverage to require more stringent terms in their NDAs. But at minimum they need to be aware of what non-disclosure agreements permit and whether they can tolerate the risk that such would create for their trade secrets.

Intellectual property is the lifeblood of many startups – their ideas and developments, and the protection for those, are often the most valuable asset they have. As for any business, these might be protected by patent and/or trade secret law. Trade secret law requires substantial effort to maintain confidentiality of the “secrets.” But this can often conflict with another goal of many startups – obtaining financing from investors, who often will want substantial disclosures before they invest.

A recent decision of the Delaware Chancery court, Alarm.com Holding, Inc. v. ABS Capital Partners Inc. (2018) highlights the tension between these two goals. An investment equity firm entered into a Non-Disclosure agreement with a technology firm, and ultimately invested substantial sums. But the agreement expressly stated that the equity firm was free to invest in or manage competing businesses. After several years, the companies had a falling out, and the investment firm acquired a competing business. The technology company sued, claiming this arrangement would lead to the disclosure of its trade secrets.

But the Delaware Chancery Court dismissed the complaint. The only basis alleged for the misappropriation of trade secrets was that personnel from the equity firm were involved in the management of the other firm. But that had been expressly permitted in the agreement – so could not be the basis to infer misappropriation.

It should be noted that the theory underlaying the complaint in the first place is controversial. Alarm.com seems to have based its claim of misappropriate merely on the fact that directors from the investment company that had served on its board later moved to a competitor. That is known in trade secret law as “inevitable disclosure” – that because an individual has extensive knowledge of Company A’s trade secrets, and has job responsibilities in Company B that would require use of such information, that disclosure would be “inevitable.”

The legal validity of that theory is very much in question. Many courts have rejected it. And, when Congress passed the Defend Trade Secrets of 2016, it expressly rejected that theory under federal law. Rather, under federal law, a trade-secret plaintiff must show evidence that someone is actually using or misappropriating trade secrets, not merely that someone’s job function would likely lead to disclosure.