Yes, they need to share confidential information, and yes, this is always a tricky situation.
Because no rational company would ever acquire another one without knowing all the facts, there needs to be complete disclosure (and indeed, it is highly likely that in the final closing documents there will be representations and warranties on both sides, that can be very costly if everything is not disclose).
The way parties to the negotiation try to protect themselves is by executing a Mutual Non Disclosure Agreement, which prevents them from disclosing any confidential information to anyone else, and, theoretically, from making use of the information themselves.
Practically, most companies will generally start off by providing the other with general information, and only progress to super-sensitive, detailed material as the negotiations get more serious.
For cases with super-secret intellectual property such as secret formulae or software code, in some cases the receiving party will engage an independent third-party reviewer trusted by both parties to look at the secret sauce, subject to all kinds of confidentiality provisions.
Finally, particularly in large company acquisitions (but highly unusual for small ones) the parties might negotiate a "break-up fee" which the bigger company will pay to the smaller one if the deal ultimately falls through. In theory, this is designed to cover the costs to the smaller one in terms of lost profits, deal expenses and foreclosed opportunities. It would also cover any estimated damage from the disclosure of confidential information during the negotiations.
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