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Venture Capital Firms and Non-Disclosure Agreements

Many VC's will refuse to sign non-disclosure agreements.  Should this concern you?

Many VC’s will refuse to sign non-disclosure agreements. Should this concern you?

Traditionally venture capital firms looking to add potential portfolio companies have been unwilling to sign non-disclosure agreements (“NDA”) during initial discussions with entrepreneurs about their technologies and execution strategies. This unwillingness from VC firms to sign NDA’s stems from a number of reasons, including: (1) minimizing their susceptibility to legal action, (2) avoiding restricting their investments in a particular industry sector, (3) avoiding conflicts of interest, (4) avoiding wasting their time and resources, and (5) VC firms deem NDA’s unnecessary because VC’s realize the negative consequences to their firm’s reputation should they improperly use proprietary information provided to them by entrepreneurs.

Potential Investor Liability

A large reason VC firms have been hesitant to sign NDA’s with any potential portfolio companies is because of the fear that such NDA’s would expose them to potential lawsuits over disclosed information. Investors at VC firms typically look at a number of similar pitches and similar technologies from different startups all within the same industry. Thus, investors fear that signing NDA’s with any one startup will limit the investors’ ability to fund any startup company without exposing the investors to legal action. Additionally, because of the sheer amount of pitches heard by investors from the multitude of startups within the same industry, investors lack the internal resources to adequately monitor compliance with multiple NDA’s signed with these multiple startups. Thus, most VC firms have opted out of signing NDA’s with startup companies because of the risk that doing so could open their firm to a breach of contract due to the large amount of similar technologies looked at in certain industries.

Building a Portfolio

Closely tied to this issue of minimizing legal liability VC firms in the past have stayed away from signing NDA’s out of the fear that signing such agreements would restrict investors’ ability to make informed and strategic investments in multiple startups within the same industry. The strategy used by VC firms is to build a portfolio by investing in multiple startup companies within a certain number of industries (normally high-tech). VC firms build these portfolios in the hope that a few of the many startups invested in will be successful and bring a rate of return high enough to compensate for the many startups invested in by the VC firm that will fail. Investors fear that signing NDA’s would hinder their ability to build portfolios and realize returns on their investments, and because of this they generally refuse to sign such agreements. If VC firms were forced to sign such NDA’s there would likely be a lot less cash available to entrepreneurs, and the startup climate in the United States would suffer.

Potential Conflicts of Interest

VC firms have also been reluctant to sign NDA’s in the past because of the potential conflicts of interest posed by these agreements. Investors in VC firms many times serve as advisory roles or are on the boards of directors of their portfolio companies. In such a capacity these investors may have a fiduciary duty to disclose information and opportunities to these portfolio companies, but could be prohibited by the NDA from disclosing such information to other portfolio companies.

Reducing Transaction Costs

Along with potential conflicts of interest, NDA’s require a good amount of time and money to negotiate the terms that will go into these agreements. Because investors in VC firms meet with a large number of potential portfolio companies, the amount of time and money needed to draft and specifically tailor NDA’s for each startup would be overwhelming. Thus, investors have traditionally felt that it would not be feasible for them to sign NDA’s for potential portfolio companies because the time and money put into doing this would outweigh any benefit derived from them. And lastly, a side argument posed by VC firms is that if the firms’ investors ever did steal confidential information from a potential portfolio company, such an act would damage the firm’s valuable reputation to the point that any benefit derived from the confidential information would be negligible.

Some Exceptions to No NDA’s

Despite all the reasons for why VC firms generally do not sign NDA’s when sifting through potential portfolio companies, there is commentary suggesting that VC firms are increasingly open to targeted use of NDA’s.  NDA’s are more common for VC firms investing in life sciences or material sciences companies where disclosure of highly sensitive, yet discrete, formulas, compositions, and clinical data is necessary. A few years ago, many VC firms increased their focus in later-stage portfolio companies.  This is likely a result of VC firms attempting to avoid risk in building their portfolios. This trend has resulted in VC firms being more willing to sign NDA’s with these later stage companies. This is because VC firms are dealing with sophisticated companies who have developed detailed trade secrets that are more reasonably subjected to confidentiality obligations. These later stage companies are more sensitive about disclosure of their proprietary information and may not want to proceed with talks prior to execution of an NDA. It is likely these later stage companies have more bargaining power when shopping for VC funds. Thus, VC firms are more willing to sign NDA’s with these later stage companies in an attempt to get them to the table.

Additionally, there has emerged a heightened competition between VC firms for the hottest and most profitable deals. As a result, investors are more willing to deviate from traditional practices and sign an NDA in order to attract sought after startup companies. Also, newer VC firms who are less likely to rely on their firms’ fledgling reputations have been more willing to open up and sign NDA’s as a way to garner the trust and support of potential portfolio companies.

Conclusion

Now it’s more likely because of the changing VC landscape both externally, in the form of increased competition, and internally, in the form of later stage investments in potential portfolio companies for investors in VC firms to be more willing to sign NDA’s when looking for companies to invest in. Overall though, it is still standard practice for VC firms to not sign NDA’s when looking for potential portfolio companies to invest in. This in the long run will create value for both entrepreneurs and investors alike because (1) the transaction costs avoided by not having to negotiate NDA’s likely results in savings being passed on from VC firms to entrepreneurs, (2) the decreased legal liability for VC firms who need to build a portfolio of startup companies to stay in business and be profitable, and (3) the increased availability of funds available for entrepreneurs because of such VC firms decreased legal liability. Therefore, VC firms not signing NDA’s pose benefits for entrepreneurs and investors alike. However, every VC firm and investor varies in their personal preference and practice. It would be best to do independent research on any potential investors to find out what their personal policy is about signing NDA’s before beginning talks with a startup. 

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