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What to Watch Out For
Sometimes a company will ask you early on to sign a nondisclosure agreement.
A nondisclosure agreement (or confidentiality agreement or NDA) is an agreement in which you agree to keep a company’s confidential information confidential. In the broader business world, companies consider almost all their information confidential unless it is publicly available on their website, for example, or has been made public through press releases or financial filings. The startup world is a more specialized context, in which the investors will need to know a lot about a company before they consider investing, and will likely be pitching to groups of potential investors and sharing key details of the business in the process.
founder It would be atypical to sign a confidentiality agreement as part of the early conversations with an entrepreneur. Unless you are truly accessing and reviewing company confidential information, such as full customer lists, source code for a patentable software algorithm, chemical formulas, or other intellectual property that represents the core innovation of the company. That typically wouldn’t happen until you were deep in due diligence. Business ideas, early revenue numbers, and other elements that you would expect to find in a company’s pitch are not normally what an investor would sign an NDA to gain access to. Unsophisticated founders may ascribe a lot of value to their idea. Experienced investors know that there are very few unique ideas and that the largest determinant of success is whether the team can execute the idea quickly and effectively.
danger You should be wary when asked to sign an NDA, especially if the request is made early. If you sign one, and the company then shares its “business idea” with you, and you decline the investment—but then decide to invest in another company with a similar idea—the first company may threaten suit, claiming you violated the NDA and “stole” their idea. As absurd as this may sound, people have been sued in situations like this.
If you are asked by a company to sign an NDA early on in your discussion, you should politely decline. In general, tell the company that it is not typical for a prospective investor to sign an NDA when discussions are still at a very high level. If there is pushback but you are still interested, you can refer the company to one of the many resources on this topic, such as those by Paul Graham, who wrote:
If you go to VC firms with a brilliant idea that you’ll tell them about if they sign a nondisclosure agreement, most will tell you to get lost. That shows how much a mere idea is worth. The market price is less than the inconvenience of signing an NDA.Paul Graham, ”How To Start a Startup”
If you proceed into more detailed due diligence, then it might be appropriate and reasonable for you to sign an NDA. For example, if a company wants to begin sharing detailed intellectual property information and wants to protect its intellectual property rights and ability to patent its inventions, then an NDA may be called for. Down the road, if you are going to receive information rights from the company and receive its financial statements, or board observer information, it is typical to sign a confidentiality agreement with respect to that information.
danger If you are going to sign an NDA, ensure that it doesn’t include any type of covenant that will prohibit you from investing in any other deal that you find. Make sure it doesn’t include any sort of non-compete or non-solicit clause, and that it has the standard exclusions (see section 3 of the example NDA included in the appendix).
Inducements To Invest Early
Sometimes companies will offer an incentive to invest before a certain date. For example, you might see incentives like these:
An investor who invests before a certain date may get warrant coverage, or
An investor who invests before a certain date may get a better price per share (this could be done, for example, by selling the shares at a discount to the price per share for investors who invest before a certain date).
caution These promises are not necessarily problematic from a legal point of view, but we would caution not to permit these inducements to cause you to jump into an investment in haste. It’s not worth getting a good price on a bad deal.