The Startup NDA Conundrum

 In Raising Capital

Founders often face a conundrum when seeking investment for their startup:

Should a startup require prospective investors to sign a non-disclosure agreement (NDA) before receiving the pitch?

An article in the New York Times on July 2, Why More Start-Ups Are Sharing Ideas Without Legal Protection, discussed this conundrum.

Understanding the custom of investors concerning NDAs and knowing how to deal with that customer (and protect the startup) is essential for the startup founder seeking investment.

Unfortunately, though the overall point of the article – that prospective investors will not sign NDAs to hear a pitch – is correct, many of the points it discusses are not completely accurate.

First, the article claims that this is new development in the past 10 years. It is not. For at least the past 20 years (since I’ve been practicing in this area) investors have refused to sign NDAs before hearing pitches or looking at investment opportunities.

Why?

The investor’s refusal to enter an NDA makes complete sense.

As one investor points out in the article, investors will see hundreds of opportunities a year. Most of these come in batches – the startup genre of the day (e.g., social media platforms). And those same-genre-opportunities often overlap in technology or market or both. In many cases, different startups are going after the same opportunity with very similar technology or approaches.

An investor who signs NDAs with one startup puts himself in harms way for a lawsuit if he invests in another similar startup (or eliminates his opportunity to invest in the genre at all).

Though the article advises “Do Not Ask Unless You Have Something to Protect”, the reality is that you should never ask an investor to sign an NDA to hear your pitch.

This should be a non-issue for startups.

Of course, the best method for protecting confidential information is not to disclose it (the article correctly advises to proceed gradually). There’s simply no need to show up and throw, spewing all of the secret sauce up during a pitch.

Instead, founders should be able to state the “what” of the business, without giving away the secret sauce (i.e., the “how”). For example, the operation of software can be displayed without describing the trade secrets in the source code. Likewise, the results of the use of a product can be discussed rather than the method of making the product.

Where there is a secret sauce – an often there isn’t any – it can be disclosed after the pitch when (if) the investor shows interest and the relationship is further developed.

I’ve found that technical founders especially fall victim to show up and throw up because they focus on the technology rather than the business aspect of the startup.

What If the Business Idea IS the Secret Sauce?

The inability to separate the business idea from the secret sauce actually indicates a fundamental problem with the startup’s business model.

If there is no difference between them, then there’s no secret sauce and nothing to protect. A business cannot protect a secret sauce like that after launch. Once such a business becomes operational, all will know the alleged secret sauce merely by seeing the business in action.

Such a business isn’t one in which rational investors will invest in any event.

What About the Value of the Idea?

Perhaps most importantly, ideas are worth nothing (one of the interviewed investors says one percent).

Why? Because ideas don’t create great companies. Execution does. Investors invest in teams who can execute to create a business.

Plus the original idea almost never pans out. Most startups change their business from the original idea (often many times) before hitting on a winner. This is the basis for lean startup methodology, and the concept of the pivot.

Therefore, ideas by their very nature aren’t secret sauce. Rather, it’s the behind-the-scenes details of method of implementing and executing the idea to create the outcome for customers that is the secret sauce.

And by keeping the idea secret, the startup loses the opportunity to test it on the intended market, to secure advise and to develop relationships with possible investors.

Pitching an Idea v. Pitching an Early Stage Business with Traction.

While a startup in California might be able to pitch investors at the idea stage with the intent to secure funding, here in Florida there must be something more.

By the time a founder is pitching prospective investors in Florida for funding, the startup must have had some success (though not necessarily be profitable) with its business model and be able to show a product-market fit. In other words, it must be an early stage company and have a bit of traction.

This adds a measure of protection for the startup – a head start with the customers and experience of what works and doesn’t work with the business model. This market relationship and experience is invaluable. And the details need not be disclosed to make a valid pitch.

It is extremely difficult (if not impossible) for someone to hear the pitch and be able quickly create a duplicate that relationship and experience. As anyone who’s done it can attest, there’s a lot of trial and error to get from idea to operating business – experience that can’t simply be duplicated.

An NDA Provides a False Sense of Security.

As noted in the article, an NDA leads to a false sense of security. Startups can’t afford to enforce an NDA because they don’t have the resources to hire attorneys or to devote time to a litigation.

More than just a waste of time, having an NDA can lead to disclosures that shouldn’t be made in any event.

Instead, the startup should use measures that will actually be effective to protect the secret sauce – don’t disclose until it makes sense to do so.

Is a Provisional Patent a Substitute for an NDA?

In a word, No.

A provisional patent application is not enforceable. It is merely a placeholder for a filing date to secure (hopefully) first-in-line status for the startup’s patent application. To get to an enforceable right, the startup must devote resources. And the filing starts a twelve month clock when the full application must be filed.

I’m often amazed at the irrational focus of startups on patents. Patents for most startups are a Siren Song. Chasing them drains startup assets for fees and costs and takes time of the founders away from developing the business. And they don’t offer the barrier to entry startups crave.

Patents are the polar opposite of an NDA. Securing a patent requires a full disclosure to enable a skilled person to practice the invention. In other words, the secret sauce is laid bare for all to see.

After making the secret sauce public, patent law leaves it to the startup to protect those rights. The startup must use its resources to prosecute infringers through legal actions. Infringement actions typically cost $2MM to $10MM in attorneys fees and take two to three years to complete; money and founder focus diverted from growing the business.

This is why it is imperative for a startup to have a cogent intellectual property strategy.

Isn’t This Strange to Hear From an Entrepreneurship Lawyer?

Part of advising clients properly as a lawyer is to understand the customs and norms of the practice area. This is simply the reality for startups in Florida.

That said, this discussion certainly doesn’t mean startups should forego NDAs.

Rather, outside of prospective investor pitches and outside of the discussion of the startup idea, all disclosures of confidential information should only be done when necessary and only pursuant to a non-disclosure agreement drafted for the specific purpose of the disclosure.

Please comment on this post if you have any questions or a contrary view.

Ed

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