Startup Fundraising Basics: Why VCs Don’t Sign NDAs (and How to Effectively Protect Your Business Idea from Getting Stolen)

 By Martin Luenendonk| 2017-07-24T22:36:34+00:00 July 10th, 2017|

Your business idea is often the most precious thing in your world.

You want to protect it from the outside world.

The fear of having someone steal your most previous business idea is not irrational. Indeed, according to some estimates, theft of trade secrets costs the US between $225 and $600 billion a year.

The more you share your business idea, the more you increase the chances of someone essentially taking the idea and doing it before you.

That’s why you want to protect your idea.

The choice of protection for many entrepreneurs is a non-disclosure agreement (NDA).

You might want to make anyone who peaks into your idea to sign such an agreement.

So, you walk to your investor meeting and present them with an NDA. And then they’ll laugh at your face while pointing you the way out.

What?

Why don’t VCs sign NDAs? Is there anything you can do about it?

Let’s find out.

So, what is the NDA anyway?

Non-disclosure agreement (NDA) is often also referred to as confidentiality agreement. Investopedia defines the term as:

“A legal contract between two or more parties that signifies a confidential relationship exist between the parties involved”

It essentially has one significant function: it prevents or restricts the information either party can reveal to other players.

And if they do, the agreement will guarantee the other party will receive some kind of compensation.

So, if the VC would reveal your business idea to someone else, you might be able to recover the loss of future profits due to this.

Now, the NDA is generally used to protect trade secrets and other sensitive information from becoming public and, indeed, being revealed to competitors.

With an NDA, you can guarantee the business idea stays within the walls it is being discussed.

Pitch Deck Course

If investors won’t sign them, does it make them inherently bad?

But you might be wondering why I mentioned at the start your investors will laugh at you if you ask them to sign one?

Doesn’t the above make NDAs sound smart?

Indeed, NDAs are not useless or bad – they just don’t work with investors, especially with VCs.

On the other hand, your startup might well benefit from using NDAs in certain situations.

You could enjoy potential benefits in the following situations:

  • When hiring employeesNDAs ensure the employees can’t just pick the ideas and sell them to someone else.
  • When using third-party contractor/outsourcing part of the development of the product – NDAs guarantee you can use outsourcing and third-parties to manufacture your product without the fear of someone stealing your business idea.

When you have an NDA in place in these situations, you protect your intellectual property and trade secrets. You enjoy the benefit of litigation in case the worst happens – you won’t be as afraid of hiring new employees or using outside help.

For a startup, surviving without external help like this can be hard.

Therefore, an NDA gives you a bit more peace of mind in taking advantage of both outsourcing and hiring extra employees without making it financially super risky.

What’s the deal with VCs? Why not ask them for an NDA?

So, I’m telling you that NDAs can be useful…but just not with VCs.

You might be wondering why’s that. Why are VCs so adamant that NDAs are a ‘no-no’?

The answer really lies in the nature of venture capitalism.

Who are VCs?

VCs are a type of investor. But unlike angel investors, VCs are investing money provided by a group of people through an investment fund.

These funds are often a large collection of capital and the limited partners that invest in these funds seek high returns. Due to this reason, VCs invest in high-reward and high-risk companies and startups.

Check out where VC’s are investing money right now.

What do they do?

As I alluded above, VCs invest in companies that are able to provide the VC with a hefty return.

They raise funds from limited partners and then invest it in startups they feel are best suited to create a 10x return.

Once they get a return, they put the rest of the money to another company.

Furthermore, since the funds are often rather large, VCs have plenty of different startups in their portfolio at any one time. A VC won’t just invest in a single startup!

It’s a good thing to understand that investors in general are interested in investing not creating.

What does this mean?

An investor is someone who isn’t looking to build a business from the bottom up. Well…as in they don’t want to do the hard work.

They want to find a team of hungry entrepreneurs who will do all this ‘creating’.

They just provide any support and capital so they can to reap the rewards together with you, the entrepreneur.

As John Rampton, an entrepreneur and social media influencer, has written:

“The whole point of investments is to make their money work for them, so they can sit back and enjoy the mentoring and curating process.”

Why does this matter in terms of NDAs?

Well, it gives you a first hint to realise why they wouldn’t share your secrets.

An investor would listen to your pitch and think ‘What a great idea, I’ll steal it”. They don’t want to build a company; they want to invest in one!

How do they make money?

Another important factor to understand is how VCs make money.

This is one of the main reasons VCs actually don’t want NDAs.

It all boils down to a thing called dealflow.

An example of a VC portfolio would look like this:

Venture Capital Portfolio

You can see from the image how the return on the above portfolio amounts to a meagre 2.9x. Considering the minimum is 3x and desired 10x, even the above doesn’t have a good enough dealflow.

Essentially, the point here is that VCs require a number of investments in different startups because the majority of them won’t ‘hit big’.

VCs need to focus on having a high number of deals so the small percentage of these deals will provide them with huge returns.

And this means VCs need to talk to a number of startups at the same time.

When they’re talking, they don’t want to have restrictive NDAs in the background spooking them with a possible litigation.

Let’s look at these points a little closer.

So, why do the investors shy away from NDAs?

Now you know the nature of NDAs and the nature of VCs.

You already have an idea why asking for the disclose might not be such a clever idea – it doesn’t fit the nature of venture capital investing.

So, what are the core four reasons, investors won’t sign NDAs?

#1 It could hinder their dealflow

As mentioned above, investors need dealflow to make money.

As I also pointed out briefly, NDAs can be a quick killer of dealflow.

Why?

Because the agreement can restrict the VCs ability to talk to other startups out of fear they might breach a contract.

This will mean they avoid talking to any startup in the same industry or with a similar technology or IP. Essentially, they will have to stop talking to many startups – hindering their chances of signing enough firms to increase they portfolio fund returns.

You might be thinking why are they so afraid?

Well, it’s hard to create a detailed NDA for a startup. Drawing the line of theft of sharing of information can be hard.

The idea might not be as sophisticated as you might think – essentially, this means someone can come up with a similar product or service without anyone revealing the secrets.

However, the VCs might still face a lawsuit since the NDA will provide the legal grounds for it.

Therefore, the threat of potential lawsuit can be enough to make them avoid the NDAs to ensure dealflow remains strong.

Investor readiness checklist

#2 It could cost them a lot of time and money

As eluded to above, NDAs have the potential to cost the VC a lot of money – and time.

Creating an NDA requires a lot of scrutiny.

You won’t just be able to walk into the office with one and get the investor to sign it. They would get their lawyers involved and conduct proper legal scrutiny over the deal.

The cost of hiring lawyers for this will push the deal price up. Since the investment deal will also stall, the VCs are set to waste time and money sorting it out.

In addition, the cost of litigation would be high.

If things go sour and the VCs are sued, they will need to spend a lot of money on hiring lawyers and trying to win the lawsuit.

Not to mention the potential cost of losing the case – if they are deemed to have breached the NDA, VCs might have to pay a high price.

All this legal process will also take time.

Court cases are not typically solved over night, legal scrutiny, due diligence, all of it will take the investor attention away from making money.

For VCs, time really is money.

Read what Keith Gillard, general partner at Pangaea Ventures, wrote on why NDAs and VCs just don’t go together:

“Imagine the thousands of contracts we would have to keep track of, on top of, and be worried about, on an ongoing basis. Imagine having to prove for every one of those when we had last communicated with the company so that we could know when we might be able to destroy the contract. Imagine the legal fees we would incur each year just to review and negotiate all these contracts.”

#3 It could cost them their reputation

The above also leads to the third important reason investors won’t sign NDAs: reputation.

Imagine if a VC firm is sued for breach of confidentiality. The simple act will be in the news, on social media and any startup that is looking to invest will now think twice working with the firm – even if the VC is cleared.

And imagine if they are deemed guilty!

Why would anyone want to work with a VC that gives away trade secrets?

Which is rather why it makes no sense to reveal these secrets.

VCs get a good dealflow when their reputation is good.

Startup owners want to work with firms that have a good reputation and with VCs who are friendly and reputable.

There’s no reason VCs would ruin this by going around giving away secrets – the stakes are too high.

Watch this awesome interview with VC partner Marc Andreessen on how his venture capital model works and how it finds and evaluates great entrepreneurs to invest in.

#4 VCs value execution not some random technical detail

Finally, VCs understand that your startup’s true value comes from your ability to execute the idea, rather than just a pure technical detail or such thing.

The value is in your ability to make the right decision. The product or service alone won’t make it – not everyone would have sold millions of iPhones; it took Apple and Steve Jobs.

Therefore, as I’ll discuss further later on, you don’t need to reveal the magic behind your product. You simply need to make the VC understand how you’re the best person to grow the company from rags to riches.

You don’t need to use an NDA to protect your secret from the VC.

The VC doesn’t really care – they care about how you plan and execute your ideas.

Paul Jones, entrepreneur and angel investor, was quoted on a Forbes article by Eric T. Wagner:

“For entrepreneurs who think their basic idea is so good they can’t tell anyone – those folks lack the ego it takes to win the entrepreneurial game. In other words, they don’t have the moxie to think they can best execute on their idea.”

If a VC won’t sign, is it all about trust then?

You’ve now hit the nail in the head with that question.

Much of the relationship you need to build with your VC will be built on mutual trust.

The VC is taking a risk when investing in a startup at the early stage – you don’t have much else than your passion and experience to proof you’ll provide them with the 10x results they need.

Investors don’t really even invest in ideas but people.

Therefore, they are taking a bet on you and your team because they trust it to do exactly what you are saying you will.

Remember, the VC is putting a lot of money on you and your team.

On the other hand, you need to trust the investor to cheer you on. To provide you the right kind of support you need to succeed aside from the money.

It’s almost as a thank you of this respect and trust they show to you that you need to trust them not to reveal your trade secrets to others.

Showing up with an NDA to a meeting with an investor is like showing up to the meeting and saying, “Hey, I don’t quite trust you, but let’s make a deal”.

It’s also a sign you don’t really understand how fundraising works nowadays.

Remember the bottom line: it’s not in the investor’s interest to reveal these all-important secrets.

What other options do you have?

Of course, you don’t need to just have blind faith in the VC.

Not asking the VCs to sign an NDA doesn’t mean you’ll be exposed and all you have as protection is trust the VC won’t do anything.

You could and should do a few other things do to protect your trade secrets without an NDA.

The three most crucial things to keep in mind:

#1 Conduct proper background check of the investor.

Don’t walk to the first investor you find and spill the beans. What I mean is that you shouldn’t just walk around talking to VCs revealing every detail of your business.

You wouldn’t hire the first IT consultant you meet and so you shouldn’t just pick a random VC to invest.

First, VCs don’t invest randomly – most have preferences in terms of the kind of startup, industry or amount they invest. You need to understand what you want from the investor first.

You also need to understand there are good and bad VCs.

To find the good ones, you need to conduct due diligence and research. You need to check the investor’s reputation.

As mentioned, previous startups would start talking if investor reveals sensitive information or is a douche. By doing a proper background check you learn whether the investor is worth trusting – if they are, you don’t need to worry too much about the lack of NDA.

How to research VCs

Things to check from your VC

#2 Remove any sensitive information that isn’t essential from the pitch.

When you first pitch to the investor, your pitch deck and the pitch itself doesn’t need to contain a lot of technical information about your product or service.

You don’t need to give a detailed account of what you are doing and how you are doing it.

You simply need to present your broad idea, convince the investor it works and prove them you are the best person for executing the idea.

You can hold any information you deem too sensitive and reveal it only after you’ve created a relationship that lasts.

This also means that if you share your pitch deck, you don’t want to include detailed information to the slides (these can be shared more easily). If you need to mention a function, then do so verbally when you give the pitch.

On the other hand, you can also keep the details to yourself. Let’s say you’ve discovered a way to code an app. But instead of saying (or writing):

“By connecting module C to module E, we can cut the load times by seven times.”

You should say something like:

“We’ve found a new way of connecting the modules, which helps us reduce the load times.”

Investors don’t need to know at this point how you’re doing it – you just need to convince them you know what you’re doing.

You can keep the details secret and focus on pitching your execution.

Remember, if the investor asks something and you feel uncomfortable revealing it, just say so and be honest.

The initial focus should be on the business model and the commercialisation of the idea – not the specific technologies or secrets.

#3 Consider using a pitch-sharing platform.

Instead of just e-mailing your pitch deck and therefore, exposing some of your secrets to a wider audience (e-mails could be hacked or shared without your knowledge), you should consider sharing it on a pitch-sharing platform.

These platforms allow you to control who views the presentation and what they do with it. You will see if suspicious people are reviewing the document or sharing it further and revoke the access.

There are even platforms which allow you too see which slides are viewed the most or the longest – this gives you a good understanding of what the investor is focusing on.

Some pitch-sharing platforms to check out:

The above are great tools in protecting your business idea, while also attracting the investor to invest.

In addition, don’t write off NDAs completely in terms of your VCs. There are certain circumstances where investors might agree or even suggest the use of NDAs.

This typically happens during the later rounds when you’re already an established company. At this point, your trade secrets are also more sophisticated and therefore, easier to protect in detail.

If you still feel the NDA would be essential during these later stage fundraising rounds, you can discuss them with a VC.

Asking for an NDA won’t provide you with extra protection; it’ll hinder your investment chances

So, while NDAs are definitely a good tool for entrepreneurs, they aren’t something you want to use with an investor, especially a VC.

This is down to the special relationship VCs and startup founders have – a relationship that is built on mutual trust.

Because of this, the use of NDAs with a VC would be counterintuitive. An NDA essentially says you don’t trust the investor to keep the secrets to himself and you don’t know if they’d work for your best interest.

Asking a VC to sing a NDA could be costly – you are likely to receive an outright rejection. Your pitching won’t really even start.

You want to avoid NDAs with VCs.

Instead get them excited without spilling the beans. Find the way to sell your idea without revealing your biggest secrets.

2 Comments

  1. Sebastien Marion July 10, 2017 at 5:41 pm - Reply

    Thank you for writing this Martin, it was a good read.
    I believe that: “An investor would listen to your pitch and think ‘What a great idea, I’ll steal it”.
    Should probably have been “An investor would NOT listen’.

    • Martin Luenendonk July 10, 2017 at 5:53 pm - Reply

      Hi Sebastien, 99% of investors will NOT steal your business idea, because they don’t want to do the hard execution part, but want to invest money, so you as an entrepreneur can execute. Still there are ways of how you can communicate your business idea and startup in order to minimize the probability and negative consequences of your idea being stolen. 🙂

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