By: Nick Callais
Why VCs Do Not Sign NDAs
Entrepreneurs looking to raise venture capital may wonder why prospective VC investors are so unwilling to sign Non-Disclosure Agreements (NDAs). NDAs are a great way for startups to protect their valuable ideas and trade secrets from getting into the hands of competitors; but to Venture Capital firms, NDAs represent a significant liability and administrative burden. Additionally, other unintended issues are created by pushing NDAs including VCs losing interest, not having an opportunity to get great feedback from prospective investors and causing credibility issues in some cases. While it is a risk for startups to operate without NDAs, these entrepreneurs can do checks on the counterparty to ensure that they are legitimate professional investors and can find significant value and potential investment by doing so.
Liability
Guy Kawasaki said it best in his Venture Capital Wishlist Blog Post
“Before you even start addressing the hard stuff, never ask a venture capitalist to sign a non-disclosure agreement (NDA). They never do. This is because at any given moment, they are looking at three or four similar deals. They’re not about to create legal issues because they sign an NDA and then fund another, similar company–thereby making the paranoid entrepreneur believe the venture capitalist stole his idea. If you even ask them to sign one, you might as well tattoo “I’m clueless!” on your forehead.”
While the above quote is quite harsh, it does cover the main liability that’s created for VCs by signing NDAs. Out of the thousands of companies being considered in a given period, we do see quite a few competing deals (often with different flavors) attacking the same problem. A few VCs even target a specific concentrated problem to be solved and fund multiple companies in the same space as an investment strategy. This means that liability is being created by signing NDAs when you see or have multiple portfolio companies in a race for market dominance.
VCs often monitor and communicate with companies that aren’t ready for investment from their perspective. VCs know that very often the company’s stage and situation may change putting them in a position that meets the VC mandate. If VC firms went around sharing company trade secrets with others, it would shrink the universe of future potential investment prospects. Plus the challenge isnt having an idea, its executing on it.
As Brad Feld stated, “as an entrepreneur, don’t think of this as “arrogance”, think of it as “practicality.” Your friend the VC is actually trying to save you time and money. If you think you have something super-secret that no one else should know, just don’t tell me about it. Oh – and check your assumption in that case – especially since the value is in creating the thing, not simply having the idea.”
It’s important to quickly engage prospective investors rather than going through the NDA process because most VCs will not be a great fit for a startup. This is based on the industry or generalist mandate of a fund, the size of the company and stage of funding that the VC targets, and exposure to a particular industry by the VC fund. Signing NDAs would be a time-consuming initial process for all parties to only later find out that the deal may not be appropriate for the prospective investor given their mandate. It’s important to understand your counterparty’s mandate and by doing so, can provide comfort to all parties that the intent is good by all.
There are a few situations that can warrant NDAs, but normally this is much further into the diligence process when an investor is doing due diligence into certain types of corporate data, especially for more science, pharma and deep tech focused companies.
Time, expense, and effort:
VCs manage many portfolio companies and are working through diligence for a number of others at any given point in time. It takes quite a bit of time, effort, and often legal expenses to go through the process of reading NDAs, making sure they are not unreasonable, and potentially going back and forth with lawyers. This is all before the VC can actually learn about the entrepreneur’s ideas which may not be a fit based on the information provided post-NDA. Many VCs may lose interest during this process which can potentially prevent further engagement. Additionally, if NDAs were signed with every startup, a significant file, function, and process would have to be created to keep track of these legal documents.
Credibility
Busy venture capitalists can see this NDA request (unfairly) as a sign of founder inexperience before getting into the meat of what makes your concept unique and investible. This isn’t a significant problem by any means, but it can hurt first impressions with certain VCs.
Understandably, founders are very excited about their companies and want to protect company information via a legal document. However, in the venture capital universe, information is treated with high confidentiality without the formality of an NDA and entrepreneurs should be aware of this dynamic before speaking with institutional investors.
As John Rampton said, venture capital regulators would have serious problems with investors going around stealing ideas from startups and sharing them with competitors. VCs would quickly lose their credibility if they engaged in these behaviors. Plus, with some preliminary due diligence on potential investors, you can get backgrounds on the team, investment approach and their existing portfolio of companies usually just by reviewing their website. If you can see that they are invested in a direct competitor, it may not be wise to share information due to potential conflicts of interest.
It’s about understanding, not copying
Prospective VCs are often individuals who have already been involved with or had significant exits in the past, have a depth of knowledge, and have relationships across industries. Since VCs review many companies, they often can recognize the trends of why some companies excel and others struggle. The advice that VCs can provide to entrepreneurs can be extremely valuable in helping to build, refine, and scale their business model, even if they don’t ultimately invest in the company.
NDAs seem like a great way to protect your incredible billion-dollar idea from others, but the reality is that VCs aren’t looking to build a competing company, they are minority investors often with affiliate controls. They are looking to give capital to high performing teams to execute on their business model in order to produce large potential returns for their limited partners. Researching the counterparty and looking for shared connections is always a good idea when you are uncomfortable sharing information with others. It will always be extremely challenging to get value-add VC investors to sign NDAs but working with them can be worth it.