(and Why Entrepreneurs Should Too)
Entrepreneurs always have questions about non-disclosure agreements (NDAs) as a means of protecting their business ideas. A consultation with a number of investors and of the blogosphere provides insight into the use of NDAs and the reasons entrepreneurs shouldn’t expect investors to sign them.
So, what exactly is an NDA? An NDA, also called a confidential disclosure agreement, confidentiality agreement, or secrecy agreement, is a legal contract between two parties that specifies confidential information that the parties wish to share with one another. An NDA restricts this information from generalized use, ensuring the parties do not disclose certain information. NDAs are typically signed when two companies or individuals are considering doing business together and need to understand certain details of one another’s businesses to evaluate a potential business relationship.
Why do some entrepreneurs want NDAs? Entrepreneurs may feel they need a signed NDA before revealing their ideas to potential investors (or any third party) for their own protection. Many worry that others will steal their ideas or share information with their competitors.
Whatever the reason behind the request, investors generally feel that entrepreneurs should not expect, or even request, them to sign an NDA. Such a demand can significantly hinder the attention investors will give to your idea.
Why don’t investors like NDAs? Most professional angel investors and venture capitalists EVADE non-disclosure agreements for the following reasons:
Expectations. Like a marriage, when an investor and entrepreneur form a union, there should be an expectation of trust. It is important the investor-entrepreneur relationship begin with trust and then build on credibility and integrity, without the legal “prenup” of an NDA. Investors are not an entrepreneur’s competition, so there is no need to be on the defensive from the get-go.
Although there is no investor oath (like the Hippocratic Oath taken by doctors), good investors follow unwritten, ethical procedures and won’t reveal your private business information. Their reputations are extremely important. They are fully aware that if they break trust or treat entrepreneurs unfairly, they will have a difficult time attracting quality ventures in the future.
Vetting. Though most investors have a narrow focus and partners with expertise along vertical industries, sometimes an idea will come across their desks beyond the scope of their knowledge. In that case, they need to tap expertise outside their firms to authenticate the strength and validity of the opportunity. Investors asked to sign an NDA will be unable to bring in the expertise needed to help inform their decision. The investor also would be unable to share the details of the idea with interested potential co-investors.
Action. Though an NDA protects the entrepreneur’s idea, it opens the investor to potential legal action. NDAs prevent investors from listening to any other pitches in remotely the same technology. Most investors are unwilling to accept the risk of litigation should they hear about a concept similar to yours.
Often, competing companies get their start at the same time simply due to market timing, and investors don’t want to get sued for funding a competitor. Investors can’t afford to promise they won’t pursue a similar business.
Duration. Any good VC or Angel sees hundreds of proposals every week. In truth, most investors may spend no more than ten minutes making an initial determination of whether a particular proposal goes into the circular file or the call-backs.
An NDA slows down the review process, and an investor may choose to turn down an entrepreneur down without reading a thing. They definitely are not interested in extending the duration between first review of the opportunity and a deal being done due to an NDA.
Expense. An NDA is a legally binding document, and a smart investor would require a lawyer to review the document before signing. Attorney fees can range from $150 to $1,000 per hour. Then, add the cost of the investor’s time spent contacting the attorney, sending the documents, and waiting for their review. Multiply that by every NDA and it adds up quickly.
The bottom line is that angel investors and VCs see requests for an NDA as naive acts that show an entrepreneur doesn’t truly understand how they operate. Just ask former entrepreneur turned VC, Mark Suster, who plainly states “VCs don’t sign NDAs.”
So, how does an entrepreneur protect his or her idea without an NDA? You should be able to convey just enough about your business idea to have the investor say “yes” without giving away all of the ingredients in your “secret sauce.”
If you are adamant about getting an NDA, first consider sending an investor your business plan with full details, minus the section that describes your key innovation. You could include a sidebar stating that access to those details will become available pending an expression of interest and the signing of an NDA.
In the words of Andrew Warner, creator of Mixergy, “Good ideas are dime-a-dozen. Ideas are worthless. It's your execution of those ideas that will be valuable. Besides, this idea that you're so proud of now will probably change completely as you build your company." (Read more from Andrew Warner on NDAs.)
So, is an NDA a good idea? Actually, there are several instances when an NDA is not only appropriate, but necessary. If you decide to hire someone—like a software developer or consulting firm-- to perform services for a fee and doing so would include disclosure of your secret sauce, then a request for NDA would be expected. Also, when talking with suppliers or when hiring employees with access to business data such as client lists, financial data, or future business strategy, it could also be required.
If you withhold a piece of your business idea and an investor expresses interest; the investor may be a little more willing to sign your NDA. But conventional wisdom says EVADE the NDA.