Why investors and non-disclosure agreements don't mix

By Bipin Parmar

Many entrepreneurs are perplexed when they come across potential investors - VCs, angels, high net worth individuals (HNWIs) - who are hesitant or plainly refuse to agree to signing NDAs (non disclosure agreements). We go behind the scenes to examine why this is the case and explore some alternatives.

Administration issues

First consider angels and HNWIs. These individuals have very little back-office support in terms of administration, treasury and legal support. Most do not even have a proper office, as they spend most of their time on the road, either searching for new opportunities, attending networking events, studying plans or spending time with their portfolio companies.

In other words, it would be very difficult for an individual investor to have an administration system in place, which will monitor which plans they have seen so far, which ones were selected for initial due diligence, and the domain sector of each plan. An individual investor who has already invested in a number of portfolio companies usually holds a directorship position in these companies, which bring with it some obligations such as fiduciary duties and duty of care.

On the other hand, VCs have relatively good back-office support, so you would expect the situation to be slightly different, but it gets more complex. VCs are organised as individual funds with several general partners, investor partners and support staff. Each partner usually focuses on either a domain sector or a region, and the communications between partners is fragile at the best of times.

Each partner is fully loaded with their own portfolio company where they usually hold a board director's position. So, like angels and HNWIs, they also have fiduciary duties and obligations to their existing portfolio companies. This is further complicated by the fact that each partner may be looking at several deals at different stages of maturity - from initial curiosity to final due diligence. Sometimes a partner may leave the VC fund and join another VC fund, taking some knowledge with them. If VCs signed NDAs, they would be severely restricted in what they can do both now and in the future.

Conflicts of interest

All investors, whether they are angels, HNWIs or general partners at VCs, have the same obligations and duties as board directors of their portfolio investee companies. Their first duty is to inform the investee company of any material information which will impact the performance of the company. Unfortunately, this includes any information, which pertains to existing or future competition to the investee company.

So now it is easier to understand why angels, HNWIs and VCs are hesitant when it comes to signing NDAs: if they had signed an NDA and later find that the information you provided them will impact their existing investee companies they are obliged to divulge this information. Investors therefore try to avoid this conflict of interest by refusing to sign an NDA upfront. It is therefore important that entrepreneurs are aware of this potential conflict of interest, and only disclose minimal information at the beginning of a contact with a potential investor.

Entrepreneurs, founders, and their advisors are reminded to carry out their own due diligence on potential investors, and to check if there is a potential for conflict from one of their existing investee companies. It is also worth bearing in mind that most VCs will not invest in a second company that will compete directly with one of their existing investee companies, so you would be better off focusing on those investors, where the likelihood of conflict is minimised. Most reputable investors will let the entrepreneur know up front if there is a chance of potential conflict.

Bear in mind that even if there is no immediate conflict of interest, there is nothing stopping the VC in investing in another company at some future date, once they have a better feel for the specific market or domain sector, in which you are playing - thus reinstating the conflict. If they had signed an NDA, it would be in your rights to complain that the VC had taken specific knowledge from your plan to facilitate another venture - hence one more reason why the VC will not readily sign NDAs.

At The Chilli, we have said many times that fundraising requires a lot of hard work and perseverance, and it helps a great deal if you have special knowledge of who is investing, when and where. This is the domain of specialist corporate finance, angel networks and fundraising companies. It may be worth considering using their services to facilitate your fund raising objectives, thus allowing you concentrate on your other objectives which will enable you to reach your goals in a timely manner. Of course, these fundraising companies do charge for their services, and you should shop around to check their fee structure and past performance, but also bear in mind, that there is no such thing as a free lunch.

Defensible barriers of the investee company

Some VCs take the position that they should not invest in a company whose only defensible barriers are a NDA agreement. It rings alarm bells amongst potential investors, as a company should be able to protect its IP by more defensible means, such as copyright, patents or a stealth operation which will give the company a reasonable lead ahead of any potential competitor.

On the other hand, a business plan seeking funds should state the final product or service and its differentiator, (see The Chilli Value Test) rather than the method of design, manufacture or service, thus providing a sufficient degree of initial protection. If your business relies on proprietary market or customer knowledge, rather than technology differentiation, it is going to have very low barriers from future competition who can simply copy your plan, use bigger corporate resources, and squeeze you out once you have shown them how to do it. Investors are going to be wary about such business proposals.

Possible solutions

You could always state in your plan that you have proprietary 'secret sauce' - read IP - which will allow you to differentiate etc, without disclosing the actual secret sauce. If the investor is sufficiently convinced about your business case, they can always sign a restrictive time limited NDA, but in this case you should seek professional advice, which will cost you a small fee, before you present and sign any such document.

There is an option of relying on a third party verification, whereby a third party will get a chance to look at the secret sauce and confirm its existence to the potential investor, without revealing the details.

At the end of the day, you need to strike a balance between protecting your IP, the inner secret sauce, and the desire to raise enough funds to get your venture up and running. It is also said by many who have signed NDAs that they are very difficult to enforce and costly to take legal action for NDA breaches. So ask yourself, what are your objectives, and how are you going to achieve it? Without the appropriate funding, it may remain a paper plan.

Comments on this story? Send an email to the editor at Editor@TheChilli.com

© Chilli Publishing Ltd 2004

17MAR2004