Why won’t prospective investors sign my confidentiality agreement?

Why won’t prospective investors sign my confidentiality agreement?

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So, you’re an eager entrepreneur with the next best thing since sliced bread in your hands and your IP adviser has told you that you must not expose your idea without first securing a Non Disclosure Agreement (NDA).

So far, that makes sense and seems like good advice.

Next, you decide to approach investors so that you can ask them to put their hard-earned money into your fledgling business and help turn your great IP into mountains of cash.

That too makes sense and seems a reasonable approach.

Your IP attorney, or your lawyer provide you with the correct documentation — a Non-Disclosure Agreement (NDA) or a Confidentiality Agreement (CA) designed to protect your intellectual property (IP). (One copied from a mate is not a good idea, unless your mate is a specialist lawyer.)

Investors have agreed to meet with you and, to pave the way for a full and frank discussion, you send them your NDA to sign and return prior to the meeting.

Yet, they say no!?!

You’re bewildered and think, ‘Are these guys out to steal my idea? Do they not take seriously the confidentiality of my business? Will they betray my great IP to my competitors? Why are they being so difficult?!?

What is the commercial value of an NDA?

There are two very good reasons for having an NDA:

  1. To create a paper trail to protect IP prior to getting formal IP protection in place; and,
  2. As the basis for legal action after damage has resulted from an intentional breach.

The former is most commonly relevant for IP that may be subject to patent protection and, thus, must be withheld from the public domain. The latter is only relevant if it happens and if there are sufficient funds to undertake the expensive, protracted legal battle over an issue that is often harder to prove than it may seem at first glance.

Different investors will have different answers and I can’t try to answer for them all.

So, instead, I will restrict myself to those who are conducting themselves professionally and those who are intentionally seeking to invest in a portfolio of early-stage non-biotech companies (i.e. the vast majority).

If yours is not such a company or your prospective investor is not such an investor then the reality of your situation may be very different to what follows. If you are an inventor and not an entrepreneur then your situation is very different again and what follows may be instructive but, is not the right discussion for you.

The Investor’s Perspective

To build an early-stage investment portfolio an investor will typically have first meetings/conversations with dozens to hundreds of companies a year and invest in no more than a handful at best.

Investors tend to seek opportunities in businesses that they understand. So, they usually see many businesses with very similar ideas for very similar markets. This means that while you think your secret idea is unique, the investor may have already heard the same idea from one or more others.

Ethical business people, including investors, will not sign contracts which they know they cannot honour, or which make unreasonable claims on their own right to operate. An NDA can be such a contract if presented as a precursor to any discussion. To honour the contract the investor must have constant and perfect recall of every little idea and detail she/he has heard from possibly hundreds of discussions on the topic and not to speak those details in the wrong context.

Investors expect the entrepreneur to be able to explain the business opportunity without revealing the intimate detail of the “secret sauce”. There are many aspects of the business opportunity for consideration before it is necessary to delve into the intricacies of the protectable IP.

Whether the secret sauce is software (copyright), hardware (patent), branding (trademark), or process (trade secret), it’s the outcomes — the effects, the market, the pain to be solved — that is of most initial interest to the investor.

When seeking investment it is the entrepreneur’s job to be a salesperson. When selling to a customer one doesn’t have to explain the secret of the product, one only has to explain why the secret delivers a benefit to the customer that the customer values. If the entrepreneur can’t have that conversation with an investor then he/she probably is not yet ready for investment.

Does the investor want to trust an entrepreneur who must tell his/her secret at the very first meeting? Does that inspire confidence in the business acumen of the entrepreneur? Probably not.

Once an investor is engaged and serious about considering an investment then it is normal to make a formal agreement on confidentiality. For example, confidentiality is a standard term in a terms sheet. If the investor doesn’t use that process then he/she may well be ready to sign a suitable NDA, one that has clearly defined coverage, lasts for no more than twelve months maximum (usually six months is more reasonable) and limits the liability for the investor to a reasonable claim for damages due to intentional breach.

A good investor will often require that the NDA be two way but, more on that below.

From the investor’s perspective, the detail of the IP is either unimportant (as it often is at first contact), so there is no need for the NDA, or the detail of the IP is of critical importance (as it often is once serious interest in the investment opportunity has arisen) so the NDA is a natural alignment of interests.

The Entrepreneur’s Perspective

The entrepreneur has worked hard and long to develop something he/she sees as unique and of commercial value. Some initial advice from an IP expert has reinforced the belief that, subject to proper scrutiny and description, the IP is protectable. At that point, all too often, the entrepreneur needs someone else’s money to pay for the IP protection.

Thus, we come to the apparent catch-22 of having a secret that you mustn’t share but is the basis for convincing an investor to support the business. This is a misconception!

Investors rarely invest in the secret IP and usually invest in the commercial opportunity to sell a business based on the IP. Investors want a return, not to steal an idea, not to cheat an entrepreneur and not to be difficult to work with in a business.

To raise investment capital an entrepreneur will typically have dozens of meetings with prospective investors over a period of anything from six months to six years. The initial goal of contacts with investors should be to engage them in the market opportunity, in the vision for a solution and in the credibility of the person/team to execute/realise the success of that solution.

None of that requires disclosure of how the solution works.

As mentioned above, when seeking investment it is the entrepreneur’s job to be a salesperson. A sale is a process and the first step in that process is not to demand exclusivity. Exclusivity is either bought or earned and, in the case of raising capital, it is usually earned. An NDA implies exclusivity and that brings with it constraints on both parties. Would you ask a date to sign a pre-nuptial agreement before the first date?

Most of these NDA are one way, designed to protect the entrepreneurs IP. Will those entrepreneurs sign a two way NDA, one which protects the investor’s IP and prevents the entrepreneur from using any of the investor’s suggestions, comments, or observations without prior license from the investor to do so?

Will the entrepreneur’s legal advisers counsel them to sign such an NDA? Can the entrepreneur afford to negotiate such an NDA with every prospective investor before knowing if the investor is interested or capable of investing?

From the entrepreneur’s perspective, there must be more to the business opportunity than the core IP and there must be a story about how to build value in the business that leverages the IP.

The Reality

An advisor who tells you to stay away from investors who don’t sign your NDA before the first conversation is giving bad advice. Life is not that simple.

Make sure the advisor has the commercial knowledge, as well as the legal knowledge, to be giving commercial advice.

If not, get a good commercial advisor to complement the IP advisor. Whether one advisor or two, the advice should guide the entrepreneur on disclosure and strategy so that it is possible to have several, ever deeper conversations with a prospective investor before invoking the need for an NDA.

Protecting IP is in the common interests of the entrepreneur and the investor.

I know that Angel groups typically give a best effort undertaking of confidentiality for information submitted to them. Many VC firms provide similar assurances.

The commercial acumen to conduct business without betraying company secrets is an essential quality for any businessperson. There is a time and place for an NDA and that is once both parties have established sufficient mutual interest to know it is worth their time to delve into the deeper mysteries of the protectable IP.

Jordan Green is an experienced executive, entrepreneur, engineer, venture capitalist and Angel investor. He has over twenty-seven years experience in growing and advising technology oriented companies in Australia, USA, Asia and Europe. A Silicon Valley software veteran, Jordan was a founding partner of one of the best performing venture capital fund managers in Australia, he is co-founder and Deputy Chairman of the Australian Association of Angel Investors and Jordan founded and leads Melbourne Angels Inc.

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  • http://www.deswalsh.com Des Walsh

    I am not at all expert in this field, but have wondered about the practice of people requiring one to sign an NDA to even have a preliminary conversation. I got to the point where I told someone recently I would rather miss an opportunity than sign yet another NDA to hear about an “idea”. For me, this post provides a nicely nuanced framework in terms of just what is being shared (e.g. the perceived business opportunity/solution as distinct from the 'secret sauce'), timing, stages of trust and the differing perspectives of the entrepreneur and investor.

  • http://twitter.com/liubinskas Mick Liubinskas

    It's very difficult for people like us at Pollenizer to sign NDA's. We speak to at least 20 new entrepreneurs a month and ideas are cheap.

    Also, I know that 99% of original ideas don't work first time and require a lot of morphing. So you are trying to protect something which is incorrect.

    That being said, mutual NDA's that are purely about shared documents can be OK.

  • Deb

    Hi.  I am new to this, so my wording may not be correct, but it is based on information I have received.  My cousin is pushing for me to invest money into a company he likes.  He says none of the investors are getting any returns (his cousin gave him $100k) because of the companies “monthly burn rate” is $60K (I am assuming this means expenses etc?), yet he personally appears to be living beyond his means!

    My cousin suggests the money be put into his name, because he gets shares at a cheap rate, which he says he will transfer once the company is listed on the stock exchange.  That got my attention!

    A few net searches revealed this company has entered into an agreement with an overseas company, with 50 % of the shares going to the investor (?).  From what I can figure out, this company has been making money since 2008.

    The information I have says, “In the absense of a buyout, XXX anticipates an IPO via a major international exchange in late 2011 (now 2012 due to the recession, my cousin tells me) in excess of 35 cents per share.  XXX is seeking investors up to $1,000,000 at 12 cents per share (my cousin says he gets his for 1 cent).  XXX has short term and long term debt options which include 5% establishment fee payable at settlement and 10% per annum interest paid 6 monthly.  Theses can be structured as convertible notes (bonds?) if required.  Financials are available on application subject to NDA.

    I have a sneaking suspicion where my cousin is making his money.

    My cousin says before anyone will talk to me, I have to sign a Confidentiality Agreement.  A search on Free Patents Online, came up with a Patent Pending for the idea, which showed the concept in written form and in diagrams. 

     Wouldn’t a NDA be useless if the idea can be viewed elsewhere?  I would be more interested in any joint ventures and contracts this company has in place, and what their future intentions may be, if I was going to invest in a company.

    I smell a rat.

    • http://www.aaai.net.au Jordan Green

      Hi Deb, as far as the NDA goes, it sounds like it is to protect the company’s financial information rather than their intellectual property. You are right that if it is about the IP and that is available from another source then it simply relieves you of obligations under any properly written NDA. The whole thing sounds very complex for a 4 year old company with a burn rate of $60k/mth that has signed away 50% of itself to an overseas partner (for what?) and expects to do an ASX IPO this year. There is not enough information to provide an informed opinion about your rat suspicions but, based on what you’ve been able to say I would tend to agree with your concerns.

  • http://www.plaintiffsettlementsolutionsincorporated.com/ structured settlements

    If you are well planned to investment your saving money so that’s give a benefit in short term. Some people fight in a few days the perfect investment. You should choose stocks at this time or stable Eddie looks hot? You should invest in a mutual fund, or in selected few stocks?