Sunday, June 22, 2008

Non-Disclosure Agreements

Bill Snow has a great summary of why venture capital firms do not sign NDAs (non-disclosure agreements).

Here's his introductory paragraph:
Let’s take a look at one of the most common miscalculations made by early stage entrepreneurs: Asking potential investors to sign a non-disclosure agreement (NDA). In the pantheon of entrepreneurial mistakes, the NDA is right up there with the infamous line, “these projections are conservative.” Simply put, if you hope to raise money from VCs, you increase your chances of success by eschewing the NDA request. Most (if not all) VCs will not sign the darn things. There are bound to be some exceptions to this rule, but not many.

The rest of the article goes into why that is the case. However, the gist of the reasoning is that venture capitalists see a vast number of deals, and it is simply not feasible to enter into non-disclosure agreements with each of them. The liability and the potential conflicts are enormous.

It is the policy of most VCs not to sign NDAs for the business plans that they are sent. A simple poll of angel investors and VCs in Australia shows that many firms have similar policies. Yet, a large number of entrepreneurs approach me, and are adamant about having an NDA signed. Why is this?

I believe that this is due to cultural factors, bad advice, and ignorance of how the industry works. The cultural factors stem from, what I have perceived is an Australian bias that assumes that "people" (banks, investors, business partners, the government, etc.) have it in for the company. Rather than looking at what a business partner, such as a venture investor, can bring to a business (ie, maximizing the upside), an entrepreneur may be more likely to be suspicious on how the business partner can hurt the business (ie, minimizing the downside).

The second factor is bad advice. Entrepreneurs look to their advisors, such as their lawyers, or investment advisor (intermediaries) for guidance. I have been impressed by far too few of these professionals that I have seen. Most do not seem to understand the position that the venture/angel industry takes because they are ignorant to the industry's requirements. The entrepreneur then approaches the investor demanding an NDA, "because my lawyer said I needed one", and this can prevent things from moving forward.

The third factor is ignorance of the industry. This is, in part, what this blog hopes to correct. However, similar to point #2, there are few sources for Australian entrepreneurs to learn what the industry requirements are. When told that an investment firm will not sign an NDA, the entrepreneur does not have the background to understand why. However, I am optimistic that this is changing because a) entrepreneurs are becoming more sophisticated all of the time, and b) the number of sources of information for entrepreneurs is growing all of the time.

So, why the AVCAL NDA then? This comes from a difference between venture capital and later stage private equity. Although our friends in private equity have their own issues, discussed here and here.

So, to close I'd like to loop back to Bill Snow's article above. While asking for an NDA is not the kiss of death, starting an early stage raise with that discussion is not the way to lure in an investor. You control the information you release - keep the super proprietary details to yourself and only worry about disclosures once the deal has progressed sufficiently. I can pitch Google's value as an investment without disclosing their algorithm, and you should be able to do the same for you business as well.


Sara Goldstein said...

Hear hear re advisers in Australia!

The worst I encountered told us to ask for $10+ million in first-round funding because we "weren't thinking big enough" and would be negotiated down to a lower sum anyway. We know we can do the whole next year's development for well under $1 million, so chances are investors do too.

I'm not sure what's worst: the amount of equity we would've given up to get it, or starting the business relationship with investors by BSing them.

Either way, the only advisers I'll work with now have raised at least a couple of rounds themselves ;)

Aaron Fyke said...

That's a bizarre thing for an advisor to say - VCs tend not to negotiate on the amount of money you are looking to raise - if you want $4m, fine. If your plan calls for $8m, fine - it's your plan. The only relevant issue is whether the VC has the funding capactity to be able to support that much. As you mentioned, we would look at a deal as suspect if it is asking for $10m when it only needs $1m.

What VCs *do* negotiate is on valuation - as that's what can drive the returns. However, the only person who wins from an excessively high raise is an advisor who is paid a percentage of funds raised. The founder is badly diluted, and the VC ends up deploying a bunch of money that isn't used and then gets an awful return.

It is the perverse incentives that some advisors exploit that should be a huge warning flag that you're working with the wrong person.