You can deter imitation by keeping things secret and reducing the diffusion of information about your products or services or how you produce them. For example, suppose that you have discovered a chemical that makes an excellent fertilizer. If you run a fertilizer company, you might not want other people to know that you have identified this chemical. If your competitors and potential competitors do not know that the key to your fertilizer lies in the use of a particular chemical, then they will not understand that they need to gain access to that chemical to compete with you successfully. Therefore, they will not seek to obtain access to that resource, and they will not be able to imitate your operations successfully.
When Does Secrecy Work?
Efforts to mitigate imitation by keeping information about a new product or service secret work best under certain conditions. First, they work better when there are few sources of the information about the new product or service. To imitate your product or service, a competitor needs access to the information that makes copying the innovation possible. While your competitors can obtain this information from you, they can also get it from third parties. Your efforts to keep things secret are not going to be very effective if third parties readily provide this information to your competitors. Therefore, if only you know the information necessary to imitate your product or service, then your product or service is less likely to be copied.
This is why it is easier for Coca-Cola to keep other companies from copying its soft drink formula than it is for your local dry cleaner to keep its dry cleaning formula secret. Even if your local dry cleaner never told anyone the formula for its dry cleaning solution, you could obtain it from any of thousands of other dry cleaners. However, if the few executives at Coca-Cola who know the formula to classic Coke do not tell you what it is, then you are going to have no way of knowing it.
Second, secrecy is more effective when a new product or service is complex. Imitation involves understanding how to copy a new product or service, not just having access to formulas or blueprints. The more complex a product or service is, the harder it is for people to figure out how to duplicate it. Complexity affects people’s understanding of the order in which tasks need to be undertaken and the difficulty of choreographing the joint efforts of different people. Take, for example, the challenge of assembling a child’s toy. Even if you have the instructions, it is much harder to make the product just as the manufacturer has intended when the product is made up of hundreds of pieces than when it is made up of only a couple of pieces.1
Third, secrecy is more effective when the process of creating a new product or service is poorly understood. To imitate your activities, people have to understand what you are doing. The fewer competitors that can actually understand what you are doing, the fewer that will be capable of imitating your products, and the less imitation there will be. For example, suppose that you developed a new method for keeping storm drains clean by flushing them with a chemical mixture at certain temperatures. If the process of creating this new chemical solution was poorly understood (e.g., very precise amounts of the chemicals have to be combined at exactly the right moment under the right temperature for unknown reasons), then few people would be able to imitate this product, and your company would capture the profits from providing it.
Fourth, secrecy works best when the information that is being kept secret involves tacit knowledge—knowledge about how to do something that is not documented in written form. For example, a plant manager’s knowledge of how to keep an assembly line running at high speed through a sense of where to position different workers with different skills and a sales person’s knowledge of how to close sales by timing the introduction of personal comments into a discussion are both examples of tacit knowledge.
It is easier to imitate a well-codified process than a tacitly understood one because imitation of a codified process only requires access to the document outlining the process, whereas imitation of a tacitly understood process requires the imitator to gain access to the person who holds that information in his head. Most of the time, it is easier to gain control of a document about a process than to gain control of a person who knows about it.2 Take, for example, the case of expertise in boiler repair. If that knowledge is held in documentary form by a company in Michigan, then a company in Ohio could get control of that information and move it to Ohio more easily than it could if the knowledge was tacit and held in the minds of the Michigan firm’s employees. To copy the tacit knowledge, competitors would need to hire the employees of the Michigan firm and get them to move to Ohio to imitate the product or service.
Moreover, when knowledge is tacit, its transfer must take place through face-to-face meetings between people. In contrast, when things are codified, knowledge can be transferred by handing a blueprint or a formula to others.3 Because knowledge spreads much faster if the transfer is not limited to direct contact between people, codified knowledge tends to spread very quickly and is harder to keep secret than information that is not written down.
Fifth, secrecy works better when there are limited numbers of people capable of understanding the information that is being kept secret. The fewer people who have the skills and abilities to use the information that creates your new product’s value, the fewer people who can figure out how to imitate what you are doing, even if the knowledge that you are keeping secret leaks out. Researchers Lynne Zucker and Michael Darby at the University of California, Los Angeles, business school have shown this to be true for new biotechnology companies. They learned that the new biotechnology firms founded to exploit the technical expertise of leading scientists often were successful because competition was limited to the handful of people who also had the skills to exploit the cutting-edge scientific techniques that they used.4
Sixth, secrecy works better for processes, inputs, and materials than for products. Why? You sell your product in the marketplace. That makes the product itself observable-in-use. (In fact, the more observable-in-use a product is, the less it can be kept secret. This is also why it is hard to keep secret certain processes, such as techniques for providing customer service.)5 Moreover, competitors can buy your product and reverse engineer it to figure out how it works. 6 These things make it harder for you to keep the composition of your product secret than it is for you to keep secret the production processes used to make the product. Therefore, processes make better secrets than products.
Trade Secrets
Trade secrecy is a special case of all efforts to keep a new product or service secret. In the United States, trade secrets are governed by state law,7 primarily the Uniform Trade Secrets Act, which is in force in 44 states.8 This act defines a trade secret as “information including a formula, pattern, compilation, program, device, method, technique, or process that derives independent economic value, actual or potential, from not being generally known, and not being readily ascertainable by proper means by, other persons.” Examples of trade secrets include chemical processes; customer databases; food recipes; computer source code, manufacturing processes, architectural designs, vendor lists, and marketing plans; and sources of raw materials, design manuals, pricing policies, and blueprints.9 For example, one of the most valuable trade secrets today is Google’s Web page ranking algorithm, which makes its search engine better than others.
Trade secrecy laws provide for legal remedies if someone benefits from your trade secret without your consent. If you believe that someone else has improperly obtained a trade secret, you can sue to collect damages for your loss and obtain an injunction to stop further use of the secret. These remedies are available to you regardless of whether the party disclosing the trade secret was bound by duty of confidentiality, had signed a nondisclosure agreement, obtained the information illegally, obtained the information from someone who did not have authorization to disclose it, or learned the information by accident but knew it was a trade secret. 10
Conditions to Have a Trade Secret
Three conditions must be met for the courts to hold that something is a trade secret. First, the information must be known only by people in your company. Information that is known generally in an industry, such as standard manufacturing processes, or information that can be generated from data that are known in an industry, cannot be a trade secret.11 Moreover, you cannot claim that the general skills that your employees learn on the job are trade secrets because that would preclude them from being able to take new jobs and use the skills that they learned working for you at their new employers.12
Second, the information must have economic value. For something to be a trade secret, it must generate a competitive advantage that would be lost if your competitors made use of it. This means that you must be able to document that what you term a trade secret is central to how your company derives value and provides an advantage over your competition in the marketplace. You should note that this standard is stricter than for a patent, where all you have to do is prove infringement to collect damages.
Third, you must take reasonable measures to keep the information secret. This means that you have to adopt “secrecy policies” to ensure that people do not accidentally access the secret information. Your employees need to know what information is secret and that secret information is limited to only those personnel who need it. Moreover, those personnel who need access to the information must agree, in writing, to keep it confidential. Furthermore, you need to use physical mechanisms, such limiting the access of nonemployees to your facilities, locking files, requiring computer passwords, and so on to keep the information from getting out.13
Take, for example, the efforts by Kentucky Fried Chicken (KFC) to keep the recipe for its fried chicken a trade secret. The recipe is kept in a vault at the company’s headquarters and only a few people know what it is. Those employees who know the formula are required by the terms of their employment to keep the recipe secret. Moreover, two different companies supply the herbs and spices to KFC, but each one is allowed to create only part of the ingredients and neither company is known to the other.14
Secrecy as a Strategy
You might choose secrecy as your basic approach to protecting intellectual property. This choice may stem from a preference for trade secrets over patents as the basis for competitive advantage (the two sources of intellectual property protection are mutually exclusive, necessitating a choice), perhaps because trade secrecy offers a longer time horizon of protection or because it does not disclose information to your competitors. Or it may occur because you have a product for which secrecy is particularly effective: It is created through a process that is poorly understood, complex, and based on tacit knowledge for which there are few sources of information and a limited number of people who can comprehend it. You might even focus on secrecy to generate customer interest in your products and services because people are often more interested in things that they cannot know about than things that they can.
Apple Computer is an example of a high technology company that focuses strongly on secrecy. (A former CEO, John Scully, was fond of using the phrase, “loose lips sink ships.”) The company rarely discloses its plans for new products and compartmentalizes development efforts so that employees working on new products rarely have information about the entire product. The company vigorously maintains efforts to limit disclosure, suing employees who leak information about forthcoming products, and Web sites that publish such information. It creates lists of employees who have been given access to information about new product plans, even watermarking documents with the recipient’s name and using different code numbers for different departments to better track the source of any leak. Access to buildings in Apple’s headquarters is even limited to the part of the complex in which employees work.15
While secrecy-focused strategies, such as Apple’s, have many advantages, these benefits come at a cost. As was mentioned earlier, maintaining trade secrets is costly. It requires the adoption of secrecy policies and reduces the level of informal exchange of information among your employees, which hinders your ability to develop new products and processes. Maintaining trade secrets also hinders your efforts to work with other companies, which by necessity, lack adequate information to serve as effective partners. Moreover, it inhibits efforts to sell products to many business customers who need to know about new products long in advance of their release to fit them into their own plans. Finally, maintaining trade secrets risks the independent discovery and exploitation of your inventions. Competitors who independently and legally obtain technology that you maintain as a trade secret are free to use it, even though they would be barred from doing so if you patented the technology. For example, if other companies figure out how to create your product through legal means—reading your publications, talking to your suppliers or customers, or reverse engineering your product—nothing would stop them from making and selling exactly the same product as you.
Nondisclosure Agreements
Trade secrecy is enhanced by having people sign nondisclosure agreements that are crafted by lawyers who know the details of employment law. These agreements are important; you cannot make a case that you are keeping information secret unless your employees understand that they are expected to refrain from disclosing information.
Effective nondisclosure agreements must meet certain conditions. The agreements must specify exactly what information is to be kept secret and cannot state that all information that employees learn during their employment is confidential. Moreover, the agreement must provide consideration. That is, employees must receive something of value, such as their salaries, in return for nondisclosure. Furthermore, the agreement must specify legitimate uses for the information, including identifying those people to whom the information can be disclosed and how the information may be used to perform a job. Lastly, the agreement must state what must be done with any documents or materials that are transferred to the employee, both during employment and after the termination of an employment relationship.16
Enforcing Nondisclosure Agreements
To enforce nondisclosure agreements, you need to be willing to sue your employees and others who help them because the only remedies for violation of nondisclosure agreements come through legal action. Many companies do this. For example, Biomec Inc., a Cleveland, Ohio, medical device company, sued a former employee claiming that he violated his confidentiality agreement when he moved to rival Cleveland Medical Devices; and Wal-Mart sued Drugstore.com and the venture capital firm Kleiner Perkins when Drugstore.com hired former Wal-Mart employees who had developed that company’s system for Internet retailing.17
While the easiest case to make for violation of a nondisclosure agreement occurs when your employees take documents that belong to your company, you can make a case that they violated their nondisclosure agreements if they take only uncodified knowledge. For example, IBM recently settled a lawsuit with Compuware Corp. in which Compuware alleged that IBM had violated Compuware’s trade secrets for file management and error detection software by hiring former Compuware employees to speed the development of software for its mainframe computers. In this case, Compuware claimed that its former employees had signed confidentiality agreements and then disclosed technical knowledge and knowledge of customer preferences to IBM.18
Noncompete Agreements
Trade secrecy is enhanced by having your employees sign noncompete agreements, which bar them from working for competitors for a period of time after their employment has ended, because these agreements keep employees from moving to rivals while their company-specific knowledge still has value. For example, Microsoft successfully forced a start-up company named CrossGain to lay off 20 former Microsoft employees until the expiration of their noncompete agreements, as a way to protect its intellectual property.19
Enforcing Noncompete Agreements
As with nondisclosure agreements, you need to be prepared to go to court to enforce your noncompete agreements. For example, Patio Enclosures Inc. had to take Four Seasons Solar Products to court for hiring a former Patio Enclosures employee who had signed a noncompete agreement that barred him from employment at a competing firm for 2 years.20
While noncompete agreements help you to protect your company’s intellectual property, they are hard to enforce. These agreements need to be of limited length and limited geographic breadth because they will be declared invalid if they keep people from earning a living in their chosen field.21 For example, ExxonMobil’s noncompete agreement cannot preclude a petroleum engineer from working at another oil company after leaving ExxonMobil. Moreover, in many states, you must give employees some benefit, such as a bonus or a higher salary, in return for asking them to sign a noncompete agreement;22 while in other states, such as California, you cannot enforce these agreements at all.23
Ownership of Intellectual Property
Related to the issue of nondisclosure and noncompete agreements is the issue of who owns the rights to technologies that employees develop during their employment at a company. These rights reside with employees unless you require them to assign the rights to you. Of course, most large companies do just this, which keeps many people from quitting and starting new companies to exploit technologies that they developed while working elsewhere. For example, Jeff Hawkins, the founder of Palm Inc. computing, patented an algorithm for pattern recognition software when he was on academic leave from GRiD systems, his employer. Although he owned the patent, and his licensing agreement with GRiD allowed him to use the algorithm in noncompeting products, he did not have the rights to the improvements to the C-language enhancements he had made while he was a GRiD employee. As a result, he needed to work around this intellectual property to develop the Palm personal digital assistant (PDA).24