The Startup NDA Conundrum: When and How Florida Startups Should Use Nondisclosure Agreements
When seeking investment for their startup, founders often face a difficult question: Should they require prospective investors to sign a non-disclosure agreement (NDA) before receiving the pitch?
Understanding the custom of investors concerning NDAs and knowing how to deal with that custom (and protect the startup) is essential for the startup founder seeking investment.
A 2014 article in the New York Times discussed the issue and wondered why more startups are sharing their tech without legal protections. Unfortunately, although the overall thrust of the article is correct—prospective investors will not sign NDAs to hear a pitch—some of the points it discusses are not completely accurate.
Is This Something New?
The article claims that this is a new development in the past 10 years. It is not. For at least the past 20 years (at least since I’ve been practicing in this area) investors have refused to sign NDAs before hearing pitches or looking at investment opportunities.
Would we expect the investor to act any differently?
As one investor points out in the article, investors will see hundreds of opportunities a year. Most of these come in batches of the startup genre of the day (e.g. social media platforms). And these opportunities often overlap in their technology or market or both. In many cases, different startups are going after the same opportunities with very similar technology or approaches.
An investor who signs NDAs with one startup puts himself at risk for a lawsuit if he invests in another similar startup or eliminates his opportunity to invest in that batch of startups at all.
Though the author’s advice to founders is to “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.
Loose Lips Sink Ships
Of course, the best method for protecting your confidential information is not to disclose it in the first place, and the article correctly advises founders to proceed gradually. The fact of the matter is that there’s simply no need to show up and throw up, spewing up all of the secret sauce during a pitch. If there really is a secret sauce, it can be disclosed after the pitch, if the investor shows interest and the relationship is further developed.
Instead, founders should be able to state the “what” of the business, without giving away the “how.” For example, the operation of software can be displayed without describing specialized source code. Or the results of the use of a product can be discussed rather than the method of making the product. This is a vital part of your pitch, and it requires practice and training like anything else.
I’ve found that the technically-proficient founders especially fall victim to disclosing “how” instead of the “what” because their focus is on the technology rather than the business aspect of the startup. Again, this is why practicing your pitch is important.
The “What” Shouldn’t Be the “How”
Occasionally, I’ve heard founders object to this advice. They tell me that there isn’t a fundamental difference between the “what” and the “how.” 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 “X factor” merely by seeing the business in action.
In any event, such a business isn’t one in which rational investors will invest.
Isn’t the Business Idea Worth Something?
Perhaps most importantly, ideas themselves are worth nothing.
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. Twitter, Groupon, Paypal, Flickr, and many other companies began life as something other than what we know them for. 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 implementation and execution of an idea that creates 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 advice, and to develop relationships with possible investors.
False Sense of Security
If an investor were to sign an NDA before she heard your pitch, this may not be the best thing for your startup. As noted in the article, an NDA can lead to a false sense of security.
On the one hand, having an NDA can actually lead to disclosures that shouldn’t have been made in any event. This can be harmful to the startup and put its future at risk. If other potential investors learn that founders are disclosing truly confidential information willy-nilly, they will be unlikely to invest.
Moreover, an NDA may not offer as much protection to a startup as you might think. In reality, the strength of an NDA is partially dependent on a party’s ability to enforce it. And startups can’t afford to enforce an NDA because they don’t have the time and resources for attorneys and expensive litigation.
Instead, the startup should use measures that will actually be effective to protect the secret sauce. The bottom line is: Don’t disclose anything secret until it makes sense to do so.
Provisional Patent Applications
The article suggests that an alternative to an NDA might be to file for a provisional patent. If you’re wondering whether a provisional patent can stand in for an NDA, the answer is, no.
To begin with, 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 filing the provisional paten starts a twelve-month clock within which the full application must be filed.
In fact, 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.
To be honest, I’m often amazed at the irrational focus many startups place on patents. Patents for most startups are a Siren Song. Chasing them not only siphons off startup assets to pay for filing fees and costs, but it also takes the founders away from developing the business. And they don’t offer the barrier to entry that startups crave.
After making the company’s confidential information public, patent law leaves it to the startup to protect those rights. The startup must use its limited resources to prosecute infringers through legal actions. Infringement actions can cost $2MM–$10MM in attorney’s fees and take 2–3 years to complete. That is precious money and focus diverted from growing the business with not much to show for it.
This is why it is imperative for a startup to have a cogent intellectual property strategy.
When in Rome Florida: A Caveat for the Florida Entrepreneur
The article in The Times very much reflects the echo chamber environment that is Silicon Valley. While a startup in California might be able to pitch investors at the idea stage with the intent to secure funding, here in Florida investors need something more. We just don’t have the burgeoning investor and VC market that hotbeds like Silicon Valley do.
By the time a founder is pitching prospective investors in Florida, 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, the company needs to have moved past the idea stage and gained a bit of traction as an early stage company.
This adds a measure of protection for the startup. It has a head start with its customer base and experience tweaking its business model. This market relationship and experience is invaluable.
Importantly, these details need not be disclosed to make a valid pitch. Regardless, under most circumstances, it’s extremely difficult (if not impossible) for anyone to hear a pitch and be able to replicate the market relationship and experience. As anyone who’s done it can attest, it takes a fair amount of trial and error to get from an idea to an operating business.
That said, this discussion certainly doesn’t mean startups should forego NDAs entirely. Rather, outside of prospective investor pitches and the discussion of the startup idea, 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.
Some of what I’ve said may sound strange to hear from a business lawyer, but these are simply the facts on the ground in Florida. As an entrepreneur in Florida, you should make sure that you know what customs, conventions, and laws are in place, so you can prepare and protect yourself (the same applies to other business-related legal issues like Florida’s noncompete statute and business entity naming restrictions).
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