Editor's Note: Learn from a panel of experts and entrepreneurs who have successfully financed their own ventures and are helping others do it at the Thought Leaders Live 2013 event May 29, in Long Beach, Calif. Event and ticket information can be found here.
The business plan that arrived in the mail looked normal enough. But as the VC turned the very first page, an ominous legal document stopped him dead in his tracks. The page was a verbose, rambling nondisclosure agreement--the dreaded NDA. The VC recoiled in horror and pitched the packet into the shredder.
Sound like pulp fiction? It's not. Entrepreneurs everywhere are setting themselves up to fail by using nondisclosure agreements inappropriately. All too often, entrepreneurs insist on secrecy--for their technology, their business plans, even their core idea--to the detriment of funding, partnerships, press and even sales.
Let's be clear: NDAs are not all bad. They can be an important-even vital-part of many business negotiations. In the words of Peter Townshend, attorney at Allen Matkins Leck Gamble & Mallory LLP in San Diego, "The classic NDA is between two companies sharing confidential information. The NDA provides the basis for a claim against the other party for inappropriate use of the information."
But it is exactly that basis for claim ("cause of action" is the equivalent legal term) that people in the finance world hope to avoid. "With respect to talking to VCs and lawyers, entrepreneurs need to realize that [they] are not going to sign an NDA. By asking them to, entrepreneurs reveal their own inexperience and potentially start the relationship off on the wrong foot," warns Townshend.
Before you demand confidentiality from investors, be sure you know who you're dealing with.
VCs concur. "We have a policy that looks very skeptically at signing NDAs," says Dave Gilroy, a partner at Wakefield Group, a Charlotte, North Carolina, venture capital firm. "There's seldom a good reason for a company to demand one."
NDAs expose VCs to uncertainty, explains Gilroy. Investors look at so many business plans and meet so many entrepreneurs that it would be nearly impossible for them to keep each idea separate and confidential from the rest. In addition, negotiating and administering an NDA for each prospect would require an inordinate amount of time and effort. The result: Entrepreneurs who steadfastly require NDAs may simply be ignored.
Eventually, most investors will get around to signing an NDA. Confidentiality clauses of one kind or another are generally part of term sheets and shareholder agreements, which come later in the funding process. The key for the entrepreneur may simply be patience.
"It pays to be open from the beginning about the disclosure process, the levels of disclosure, and when you will expect the other party to sign an NDA," advises Townshend. During the early stages of financing discussions--or any business relationship--both parties should be careful to discuss only nonconfidential issues.
"There's always [nonconfidential] first steps so we can qualify the entrepreneur and his business," says Gilroy. A company should be prepared to offer an executive summary, a business plan and other top-level documents that give an investor enough information to pique his interest without requiring an NDA.
When the time comes to ask for an NDA, there are several key issues to cover. "A good NDA protects you from both the act of disclosing and the use of the information," according to Townshend. A malevolent partner may, for example, steal your trade secrets for his own use without disclosing it to anyone else. So if the NDA does not cover the inappropriate use of the information, you will have little recourse.
Likewise, disclosure itself must be stopped when possible, so Townshend further advises companies to ask for "injunctive relief"--the ability to stop the act or process of disclosure. Imagine if your trade secrets are posted on a competitor's Web site. Injunctive relief can result in a court order (an "injunction") to remove the information from the Web.
Finally, when trying to protect sensitive information, the disclosing party should ask for broad definitions of what is confidential information--having to mark every page may not be practical. To be truly useful, an NDA should protect not only written but also verbal and undocumented communications.
Go With the
Of course, there are two sides to every contract. The investor who is pledging to keep your secrets will want to be sure that an accidental slip of the tongue won't cost him an arm and a leg.
"There are half a dozen ways to try to water it down from the VC side," says Gilroy of Wakefield Group. Investors may ask for limits, for example, on the duration of the agreement, the automatic monetary damages (called "liquidated damages"), and the ability to share information among employees.
Liquidated damages, the legal term for what happens if the investor blabs, is one of the thorniest issues. An entrepreneur will try to specify substantial monetary penalties for the mere act of inappropriate disclosure. An investor, of course, will look to minimize that risk, sometimes to the point of excluding those payments altogether. Investment bankers and finance consultants may insist that monetary penalties be limited to an appropriate level, like a refund of fees received.
Finally, a savvy investor will almost certainly do a careful background check on the entrepreneur or disclosing party. NDAs can carry such heavy potential liability that investors will be extra wary of anyone with a history of filing frivolous lawsuits. Be prepared to submit to a certain amount of scrutiny to get the deal done.
Of course, the smart entrepreneur will also know enough about the investor to have confidence that sensitive information won't be misused. If a VC has already invested in the competition, the only safe disclosure is no disclosure.
"We always allow the entrepreneur to navigate that terrain," Gilroy admits. "If they feel we're more foe than friend, then there may be a reason for them to request an NDA." But it's unlikely that a VC would even ask for confidential information in such a case. As Gilroy puts it, "Our most important asset is our reputation." And any investor with a reputation for abusing other people's confidences will soon find it hard to do business.
Keep It All
Once you have an agreement, the real work begins. "Most of the time NDAs are signed and set aside," says Townshend. "But companies ought to pay more attention to what they are disclosing-to whom, when, and whether it is protected by an NDA."
Careful administration of an NDA is especially important in case of breach allegations. Although few parties to NDAs land in court, there is nothing worse than being accused of wrongly disclosing information that you never received. In any legal action, the party who does a better job of tracking what, when and how information was shared will likely prevail. Strive to keep your records straight and current.
Remember: Before you demand confidentiality from investors and business partners, be sure you know who you're dealing with and why an NDA is necessary. In any case, if you use NDAs with discretion and care, you'll be rewarded with the discretion and care of others.
David Worrell is a finance writer and business advisor in Charlotte, North Carolina. Contact him at firstname.lastname@example.org.