Disclosing the truth about non-disclosure agreements

According to everyone’s favourite web-based encyclopaedia, Venture Capital (“VC”) is defined as financial capital provided to early-stage, high-potential, high-risk, start-up companies on the back of a novel technology or business model – so is it really any wonder so much emphasis is placed on maintaining the confidentiality of information related to an entrepreneur’s innovation, novel technology or business model, particularly when disclosing aspects of it to potential third party investors? While we here at Metis Partners fully encourage the creation and maintenance of a robust trade secret policy, as well as the use of non-disclosure agreements (“NDAs”) when the situation calls for it, start-ups often jump to the latter without considering whether an NDA is appropriately crafted or, more likely, whether it’s even appropriate at all.

Historically, venture capitalists have been loath to sign NDAs, a position which has evolved for a variety of reasons, including:

(1) Though NDAs are often viewed as commonplace, start-ups must remember that they are, at heart, a legally binding document. The fact is, most VCs are unwilling to accept the risk of litigation if they hear about a similar concept from another start-up; and since VCs – CVCs included – are often looking at a number of similar deals at any given time, it’s no stretch to imagine that the “paranoid entrepreneur” might view an investor’s choice to fund a similar company as breaching the NDA and stealing their idea.

(2) If an NDA is too general in nature, as they all too often are, it might even prohibit VCs from investing in a particular industry as publicly available information might now fall within the ambit of the NDA. This is particularly problematic for CVCs, as they support new projects which are likely to be linked to the industry in which they operate.

(3) As with any other legally binding document, VCs will likely require an attorney to review the terms and conditions of an NDA prior to signing it. VCs often lack the internal resources necessary to adequately review each NDA from every company that approaches them, and subsequently monitor compliance, and the costs of implementing such a policy would be onerous. As one start-up lawyer once wrote, “only two groups would benefit: lawyers and paper companies.”

(4) There is a big difference between a conceptualised idea and an implemented idea. VCs look for people who can implement an idea, not merely come up with them; ideas are easy, it’s the implementation that’s difficult. NDAs should only be used in situations where it’s the “how,” not the “what,” that is being disclosed, that is, the unique process or innovation which will give the start-up its competitive advantage. It’s an all too common fallacy, particularly in relation to CVCs, that it will hear about an idea, recognise its brilliance and steal it or produce it itself – after all, ideas are a dime a dozen, and it’s the execution which has real value.

With that being said, there has been a marked shift from the earlier reluctance by VCs to sign NDAs, predominantly due to the ever-increasing number of VC firms and rise of CVCs, as well as a growing trend of investing in later-stage portfolio companies which may have already developed a trade secret policy that should be bound by an NDA. As a result, many new VCs – who have yet to build up the level of trust of more established VCs – have broken rank and accepted NDAs as a necessary part of discussions with start-up companies. Nonetheless, young entrepreneurs should be discerning in their use of NDAs, and must remember to tailor and narrow the scope of an NDA, but only where there’s a need to use one. Remember:

• There should be no need for NDAs prior to an initial meeting, as it is unlikely anything truly confidential will be discussed. Remember, it is the implementation rather than the idea that holds true value;

• “Confidential information” should be narrowly defined. Before drafting an NDA, identify the type of information that will be shared and require that it be shared in writing. An NDA should not capture broad descriptions of technology or publicly available information that may be accessible from other sources;

• NDAs should not include the restrictive “purpose” covenant, which restricts a fund from using the confidential information for “any purpose other than evaluating a possible transaction with the company”;

Though it might seem a risk to speak with a VC without an NDA in place, an internal trade secret policy might go a great way to alleviate some of that concern; after all, knowing the difference between the information that widely constitutes your idea versus the “bits and bytes” underpinning your competitive advantage means you’ll be well placed to know what to disclose and what to keep secret.

As published in August 2013 GCV Magazine.

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