VC Firms and Non-Disclosure Agreements: A Changing Landscape

Posted on by Justin Montis

Traditionally venture capital (“VC”) firms looking to add potential portfolio companies have been unwilling to sign non-disclosure agreements (“NDAs”) during initial discussions with entrepreneurs about their technologies and execution strategies. This unwillingness from VC firms to sign NDAs stems from a number of reasons, “including a desire to avoid restricting their ability to seek out and evaluate potential investments and a desire to continue acting in an advisory capacity for their portfolio companies.”1 VC firms have traditionally refused to sign NDAs when meeting with potential portfolio companies because VC firms (1) want to minimize their susceptibility to legal action, (2) avoid restricting their investments in a particular industry sector, (3) avoid conflicts of interest, (4) avoiding wasting their time and resources, and (5) because VC firms realize the negative consequences their firm’s reputation would incur upon disclosure of any confidential information.2

Investors at VC firms in the past have been hesitant to sign NDAs with any potential portfolio companies out of the fear that such NDAs would open them up to potential lawsuits over disclosed information.3 Investors at VC firms typically look at a number of similar pitches and similar technologies from different start-ups all within the same industry.4 Thus investors feared that signing NDAs with any one start-up would limit the investors’ ability to fund any start-up company without exposing the investors to legal action.5 Also, because of the large amount of pitches heard by investors from multiple start-ups within the same industry, investors lack the internal resources to adequately monitor compliance with multiple NDAs with these start-ups.6 Thus, VC firms have opted out of signing NDAs with start-up 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 a certain industries.7

Closely tied to this issue of minimizing legal liability, VC firms in the past have stayed away from signing NDAs out of the fear that signing such agreements would restrict investors’ ability to make informed and strategic investments in multiple start-ups within the same industry.8 The strategy used by VC firms is to build a portfolio by investing in multiple start-up companies within a certain number of industries (normally high-tech) in the hope that a few of the many start-ups invested in will be successful and bring a high rate of return that is high enough to compensate for the many start-ups invested in by the VC firm that will fail.9 Investors feared that signing NDAs would hinder their ability to build portfolios and realize returns on their investments and because of this they refused to sign such agreements.10

VC firms have also been reluctant to sign NDAs in the past because of the potential conflicts of interest posed by these agreements, and the large amount of time and money that would be needed in the formation of tailored NDAs.11 Investors in VC firms many times serve as advisory roles or are on the boards of directors of their portfolio companies and 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.”12 Along with potential conflicts of interest, NDAs require a good amount of time and money in negotiating the terms that will go into these agreement.13  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 NDAs for each start-up would be overwhelming.14 Thus, investors have traditionally felt that it would not be feasible for them to sign NDAs for potential portfolio companies because the time and money put into doing this would outweigh any benefit derived from them.15 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.16

But despite all these reasons used by VC firms to justify not signing NDAs when sifting through potential portfolio companies, the landscape surrounding VC firms has began to change. Now “VC firms have started to sign NDAs for a number of reasons, including changes to the VC environment and competition for portfolio companies.”17

With the increasing number of VC firms today, there has emerged a heightened competition between VC firms. As a result, investors are more willing to deviate from traditional practices and sign an NDA in order to attract sought after start-up companies.18 Additionally, newer VC firms who are less likely to rely on their firms’ fledgling reputations, have been more willing to open up and sign NDAs as a way to garner the trust and support of potential portfolio companies.19 Along with increased competition and less established investor reputations, VC firms have increased investments in later-stage portfolio companies.20 This increased investment in later-stage portfolio companies means that many of these companies have developed detailed trade secrets that are reasonably subject to confidentiality agreements.21 Because of these more detailed trade secrets “such companies are often more sensitive to disclosures of their information, and may not proceed with talks prior to execution of an NDA.”22

Thus, because of the changing VC landscape both externally, in the form of increased competition, and internally, in the form of later stage investment in potential portfolio companies, investors in VC firms are now somewhat more willing to sign NDAs when looking for portfolio companies to invest in. The direction this landscape moves in will determine if such a trend continues or ends.

  1. Morgan, Lewis & Bockius LLP, http://www.morganlewis.com/documents/VCPEFdeskbook/VCPEFdeskbook_ShouldVentureCapitalFirmsSignNDAs.pdf (last visited Oct. 6, 2013). ↩

  2. See id.; Jerome Gentolia, Why Startups Shouldn’t Ask Investors to Sign NDAs, VentureStab (Feb. 18, 2011), http://www.venturestab.com/2011/02/why-startups-shouldn%E2%80%99t-ask-investors-to-sign-ndas/; Entrepreneur vs. VCist: The Curse of the NDA, Forbes, http://www.forbes.com/sites/ericwagner/2013/08/27/entrepreneur-vs-venture-capitalist-the-curse-of-the-nda/ (last visited Oct. 6, 2013). ↩

  3. Morgan, Lewis & Bockius LLP, http://www.morganlewis.com/documents/VCPEFdeskbook/VCPEFdeskbook_ShouldVentureCapitalFirmsSignNDAs.pdf (last visited Oct. 6, 2013); Jerome Gentolia, Why Startups Shouldn’t Ask Investors to Sign NDAs, VentureStab (Feb. 18, 2011), http://www.venturestab.com/2011/02/why-startups-shouldn%E2%80%99t-ask-investors-to-sign-ndas/; Entrepreneur vs. VCist: The Curse of the NDA, Forbes, http://www.forbes.com/sites/ericwagner/2013/08/27/entrepreneur-vs-venture-capitalist-the-curse-of-the-nda/ (last visited Oct. 6, 2013). ↩

  4. See Entrepreneur vs. VCist: The Curse of the NDA, Forbes, http://www.forbes.com/sites/ericwagner/2013/08/27/entrepreneur-vs-venture-capitalist-the-curse-of-the-nda/ (last visited Oct. 6, 2013). ↩

  5. See id. ↩

  6. Morgan, Lewis & Bockius LLP, http://www.morganlewis.com/documents/VCPEFdeskbook/VCPEFdeskbook_ShouldVentureCapitalFirmsSignNDAs.pdf (last visited Oct. 6, 2013). ↩

  7. See id. ↩

  8. See Entrepreneur vs. VCist: The Curse of the NDA, Forbes, http://www.forbes.com/sites/ericwagner/2013/08/27/entrepreneur-vs-venture-capitalist-the-curse-of-the-nda/ (last visited Oct. 6, 2013). ↩

  9. See id. ↩

  10. See id. ↩

  11. See Morgan, Lewis & Bockius LLP, http://www.morganlewis.com/documents/VCPEFdeskbook/VCPEFdeskbook_ShouldVentureCapitalFirmsSignNDAs.pdf (last visited Oct. 6, 2013); Why Startups Shouldn’t Ask Investors to Sign NDAs, VentureStab (Feb. 18, 2011), http://www.venturestab.com/2011/02/why-startups-shouldn%E2%80%99t-ask-investors-to-sign-ndas/. ↩

  12. Morgan, Lewis & Bockius LLP, http://www.morganlewis.com/documents/VCPEFdeskbook/VCPEFdeskbook_ShouldVentureCapitalFirmsSignNDAs.pdf (last visited Oct. 6, 2013). ↩

  13. Jerome Gentolia, Why Startups Shouldn’t Ask Investors to Sign NDAs, VentureStab (Feb. 18, 2011), http://www.venturestab.com/2011/02/why-startups-shouldn%E2%80%99t-ask-investors-to-sign-ndas/. ↩

  14. See id. ↩

  15. See id. ↩

  16. See Morgan, Lewis & Bockius LLP, http://www.morganlewis.com/documents/VCPEFdeskbook/VCPEFdeskbook_ShouldVentureCapitalFirmsSignNDAs.pdf (last visited Oct. 6, 2013). ↩

  17. Morgan, Lewis & Bockius LLP, http://www.morganlewis.com/documents/VCPEFdeskbook/VCPEFdeskbook_ShouldVentureCapitalFirmsSignNDAs.pdf (last visited Oct. 6, 2013). ↩

  18. See id. ↩

  19. See id. ↩

  20. See id. ↩

  21. See id. ↩

  22. Morgan, Lewis & Bockius LLP, http://www.morganlewis.com/documents/VCPEFdeskbook/VCPEFdeskbook_ShouldVentureCapitalFirmsSignNDAs.pdf (last visited Oct. 6, 2013). ↩

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