“The only decisions an entrepreneur makes that truly matter in the long run are those that involve deciding who to trust."
Every other week or so, I am introduced to an entrepreneur who immediately sends me a non-disclosure agreement and asks me to sign the NDA before we talk further. Among other signals, this indicates that the entrepreneur has failed do almost any homework on the process of raising venture capital investment, as the blogosphere is full of well-articulated posts about the process in general and about NDAs specifically. In short, venture capitalists never sign NDAs.
My well-known VC industry colleague and prolific industry blogger Brad Feld summarizes this industry norm as follows:
“Asking the venture capitalist to sign a nondisclosure agreement, or NDA… is a stupid idea perpetuated by lawyers. Most venture capitalists will not sign an NDA, so all you’re doing is putting up a barrier to get their attention and demonstrating your naivety.”
Despite the excellent treatment elsewhere in the VC blogosphere, many of the entrepreneurs that Flywheel encounters have not been exposed to these norms. As a result, I occasionally find it useful to re-articulate the rationale here, so today I thought I would do so again. Of course, this post does not constitute legal advice.
- NDAs are a waste of the most precious resource for entrepreneurs and VC’s alike: our time. Flywheel, like most VC firms, receives between 500 and 1,000 investment proposals every year. In most years, we will invest in 3 to 6 of those proposals. As a result, the initial stages of reviewing investments are best compared to the “triage” process in a hospital. Executing an NDA for potential investments would be an enormous time sink. First we would need to review the NDA. Then, we would need to have our lawyer review the NDA and suggest any changes. Then we would send those changes to the entrepreneur, who would need to review the proposed changes with the startup’s lawyer. Even assuming minimal negotiation of changes, this process would easily consumer 2-4 hours of time and a few hundred dollars of expense. Multiply that by 1,000 businesses per year, and we would be spending a significant chunk of our time and budget simply negotiating NDAs for the 994 to 997 businesses that we will not end up investing in. Even worse, for nearly all of those businesses, we would spend far more time negotiating the terms of an NDA than we would giving feedback or advice to the entrepreneur.
- NDAs are unnecessary for initial discussions and review. A VC’s initial investment review is focused on whether a potential investment fits the firm’s stated criteria. At Flywheel, we are looking for those entrepreneurs with the most urgently-needed solutions to the world’s most pressing problems. At Flywheel, we are more specifically focused only on those entrepreneurs aiming to solve these global challenges within information technology and urban systems. We don’t invest in life sciences, consumer-facing products, or project finance. We make our initial investments in an entrepreneurial company only in the first institutional capital round. Finally, we focus our investments in those entrepreneurial companies with origins in the American West that are targeting a truly-global market opportunity. A large number of these entrepreneurs we meet are building exciting businesses, but don’t fit the criteria above. Establishing that fact quickly saves both the entrepreneur and us a lot of time, and the information needed to assess whether a business fits the criteria above can easily be provided without an NDA.
- Most entrepreneurial ideas are not very original: "Ideas are cheap and plentiful; market opportunities are rare and valuable." Entrepreneurial ideas usually result from the intersection of customer trends, technological developments, and creative inspiration. The first two of those elements are widely evident to knowledgeable observers and participants within a specific industry sector. As a result, it is not unusual for many individual entrepreneurs or teams to independently develop an idea in parallel with other individual entrepreneurs or teams who are working completely separately. As Victor Hugo famously said, “an invasion of armies can be resisted, but not an idea whose time has come.” As most VCs can attest, when an idea’s time has arrived, a lot of entrepreneurs separately and independently tend to “discover” the same idea at that time. If we did sign NDAs with each one of them, and invested in one of them, the others would invariably but incorrectly perceive that the funded entrepreneur had “stolen” their idea — and potentially use an NDA as the basis for inappropriate legal action. While the VC firm or other entrepreneur would inevitably prevail once the facts were known to all parties, this would waste enormous, unnecessary time and expense for all parties in getting to that realization.
- Asking for an NDA before an initial conversation demonstrates a lack of sales and “customer development” sophistication. Sales and customer development skills often (usually?) trump technical advantage in entrepreneurial success. One sign of basic sales and marketing skills in an entrepreneur is the evidence that the entrepreneur has spent time learning about the “customer” he or she is targeting - in this case, the VC investor. If an entrepreneur has not taken the time to do a basic Internet search about the process of raising venture capital - which will always reveal the “norms” about asking for an NDA - this illustrates a deeper hole in the entrepreneur’s sales and marketing expertise. Second, it demonstrates that the entrepreneur is either clueless or defiant of the well-established conventions of the process; neither bodes well for how a VC will assess that entrepreneur or develop trust in the relationship. Finally, it demonstrates a lack of appreciation for the value of scarce time and money in the process, and may signal a broader lack of prioritization by the entrepreneur.
- NDAs are rarely useful, even if they are signed. Other than for protection of truly proprietary, technical information (such as a new molecule for pharmaceutical purposes, a new chemistry reaction for water treatment, or the formula for Coca-Cola(tm)), the information seemingly protected by NDAs can nearly always be discovered via other channels. Many states increasingly do not enforce NDAs for “business methods” or other non-deeply-technical information. Competitors with malicious intent can always find straightforward workarounds, and pursuing legal action to enforce an NDA requires the expenditure of capital that entrepreneurial firms almost never have available for such a purpose. My advice to entrepreneurs is to consider that if a competitor can successfully beat an entrepreneurial company in the marketplace solely based on the “knowledge” gained from that entrepreneurial company, I would suggest that the entrepreneurial company’s customer relationships, recruiting ability, market execution, sales, fundraising, and product delivery skills are probably so weak that it would not have prevailed in the market even if it had not shared its “confidential” information. Of all the bases for competitive advantage in a new and fast-growing market, confidentiality is near the bottom of the rankings. For these reasons among others, NDAs are almost never enforced in the practical world, except in much larger contexts such as IPOs, acquisitions, large customer distribution deals, etc.
- Asking for NDAs signals a cultural attitude toward secrecy that can inhibit later success. The best entrepreneurs almost always succeed because they build better relationships with more open and collaborative sharing of information with customers, partners, investors, employees, suppliers, etc. Entrepreneurship is a network-based process, and a culture of secrecy usually precludes success in a network. Of course, this does not equate to widely and carelessly publishing every detail of one’s approach on the company’s website. Rather, it argues for the cultivation of the most trusted relationships in the network(s) of highest relevance to the opportunity being pursued by the entrepreneur. As Audrey MacLean, a serial entrepreneur and angel investor who was one of my early investors and mentors once put it, “The only decisions an entrepreneur makes that truly matter in the long run are those that involve deciding who to trust." Accordingly, spend less time focusing on protecting your information via ineffective tools like NDAs, and more time building and cultivating networks of those people you can trust.
- There are rare occasions when we will sign an NDA, but only relatively late in the process. If and when we are considering an investment in entrepreneurial companies with a deeply-technical competitive advantage, we will sometimes delay our due diligence of that aspect of the business to the end of the process, and then execute an NDA surrounding the technical information at that point. Typical situations might involve our verification of the performance of a new semiconductor chip design, the efficacy of the proprietary chemistry for a new water treatment process, or evaluation of the molecular structure of a new advanced material development. Since VCs are rarely technical experts at these levels (even if we had been earlier in our careers), these situations usually involve hiring a third-party technical expert to assist us with the due diligence, and that person will also be bound by the NDA. However, such situations are quite rare, and are always exceptions to the norms described above.