Most private equity and venture capital firms think that they would never be sued by their limited partners, portfolio companies or any of the myriad of other parties they’re exposed to in conducting business. General partners, when considering the possibility, often respond: “We’ve got it covered.”
Or, “Our managers are astute business professionals and our investment decisions reflect this. We know our LPs and our relationships are very good. Our hands-on’ involvement at the portfolio level is limited and the portfolio companies buy Directors and Officers Liability insurance to protect our board position anyway. We know how to handle down rounds.”
While it is true that most firms are well run and won’t be sued, it is also true that more venture firms are being sued today than in the past, and there is no assurance that good business practices alone will inoculate a firm or its partners from litigation.
At the same time, the cost of insuring against this litigation is decreasing and the breadth of coverage improving. The convergence of these two trends means that VC firms are finding better value today in insurance-just when their need is greater.
Current sources of litigation against VC and PE firms include:
Portfolio companies, primarily arising from a firm’s representation on the company’s board of directors. Typical litigation scenarios involve “control person” liability, portfolio company shareholder claims, portfolio company employee claims and complications arising out of future investments (or failure to make such investments).
Communication with limited partners relative to disclosure in investment solicitations, management of funds and overall performance of funds.
Internal turmoil, principally in the form of employment-related litigation.
These risks aren’t new, but the stakes are higher. “Private equity firms need to understand that they are higher up on the radar screens of plaintiffs’ lawyers than in the past,” says Carl Metzger, a partner with Goodwin Procter LLP, who specializes in litigation and risk management for private equity clients. “We’ve seen an increase in both the frequency and variety of claims asserted against private equity firms. It’s not just a temporary reaction to the bursting of the technology bubble, it’s a trend that’s here to stay.”
This change is largely being driven by the fact that the market is improving. For many investors, now is the right time to reap the gains on their past investments. This is fueling liquidation transactions in the form of mergers, acquisitions and initial public offerings. But, not all investors are celebrating these transactions. Those diluted by down rounds of years past may feel more pain than gain.
Down Rounds & Dilution
The “chickens from down round financings are coming home to roost,” advises John D. Hughes, a partner at Edwards & Angell LLP, who specializes in business litigation. Liquidation events uncover the unfortunate reality that dilution has minimized a founder’s, or early stage investor’s, return. “That’s when the pain is felt,” continues Hughes, “when a company is being sold and the founder’s ownership went from 28% to 3%; they don’t enjoy the proceeds.”
Struggling companies with a sink-or-swim need for additional capital were not in a position to dictate favorable terms in the down rounds of the past few years. While attempts were made to protect initial investors, new investors required liquidation preferences, many with multiples, as a condition before they would commit any capital. The results were that later-stage financings had greater liquidation preferences than founder’s and early stage financings. Founders and early stage investors suffered dilution. In this scenario, “pain” of the early investors in seeing later-stage investors benefit from the liquidation event disproportionately may equate to “litigation” against the fund and its managers.
Other M&A concerns include the fact that, unlike an IPO in which the market determines the price, an M&A transaction requires a more objective approach to due diligence and valuation. If a fund’s general partner is close to the deal, and other shareholders are unhappy with their return, they may allege that the company was sold on the cheap.
A lawsuit filed in January over proceeds of the sale of Epinions offers a real world example of this type of litigation. The suit was filed by three of the five co-founders of Epinions and 40 other Epinions employees against August Capital, Benchmark Capital BV Capital, former Epinions CEO Nirav Tolia (also a co-founder) and others.
The complaint asserts that after the VCs advised them that their equity stake in Epinions was worthless, the plaintiffs were forced into a merger agreement. Liquidation preferences gave the VC firms $45 million prior to any other distribution of proceeds, which left other shareholders, most notably the plaintiffs, with nothing since the company was valued between $23 million and $38 million.
Plaintiffs allege that key information relative to a significant contract with Google was not disclosed to them. The disclosure of this revenue stream perhaps would have influenced the plaintiffs’ decision on the merger agreement, and ultimately would have allowed them to reap the rewards later enjoyed by the VCs and CEO Tolia. After the three co-founders and other employees who brought the suit left Epinions, Tolia and others were granted vested options in the post-merger company, Shopping.com, which was a far cry from the equal treatment that the departed common shareholders were promised.
Shopping.com went public in October 2004, and, “As a result, the Epinions corporate insiders and other favored shareholders unjustly gained more than $250 million,” the lawsuit alleges. If the plaintiffs were allowed to participate in the merger “on the same terms as those insider shareholders who received preferential treatment in the merger, their equity interests in Epinions would have been worth in excess of $39 million in Shopping.com stock immediately following the IPO,” the suit claims.
Cases like Epinions offer a very public glimpse of the types of disputes firms are more typically settling behind the scenes. But whether the fight is in public or behind closed doors, the risks are always high. Nobody wants to be accused of deceit or fraud. Reputations are at stake. A firm wants the very best defense for itself and its partners and that’s expensive. And, speaking of money, who is going to pay for this defense and any settlements or judgments?
A firm and its managers can look for money to fund their defense or pay settlement or judgments from the following sources:
- The portfolio company, in its indemnity obligations to its directors, as well as any Directors & Officer’s Liability insurance it may have purchased to back stop this obligation.
- The venture fund, in its indemnification obligation to the general partner.
- Any liability insurance purchased by the PE or VC firm itself.
Each of these potential sources of recovery, however, has important limitations. Relying on the portfolio company for recovery is wrought with problems, including that the company often doesn’t have the financial capacity to fund its indemnity obligations to its board. D&O Liability insurance purchased by the company offers only modest additional security. First, the claim has to fall within the scope of the company’s policy and, second, the policy has to have enough money left in it to fund the claim. Both are bad bets from the perspective of a VC or private equity investor.
Looking for recovery from the fund also presents obvious problems. If the fund is in its later stages, is there any money left to indemnify the general partner? If not, how will the limited partners feel about having to spend their money to fund the general partner’s indemnity? Likewise, if the fund has the money, how will a potential hit in the tens of millions of dollars affect the fund’s overall performance. How will the limited partners react to a diminished return due to money spent defending the firm’s partners?
Liability insurance purchased by the VC firm itself also has its limitations but, overall, may offer the best source of recovery. Specialty liability insurance for VC firms isn’t new, but until recently, the available policies were typically expensive, difficult to understand and offered incomplete protection. For example, the standard policy offered by one large insurer of VC firms excluded claims by portfolio companies.
Pioneering a trend toward better insurance products for VC and PE firms is an insurance program available to members of the National Venture Capital Association and developed by Techassure, an association of specialty insurance brokers.
(The author is a founding member of Techassure, the endorsed broker of the NVCA.-Ed.)
Introduced last fall after consultation with NVCA members, legal experts and insurers, the Techassure/NVCA program is underwritten by several highly rated insurers. Its comprehensive design includes coverage a VC or private equity firm would expect from a policy of this type and is proving to be an attractive alternative to policies that may offer only a couple of “cut and paste” coverage enhancements. Early indications suggest that the NVCA program is also making this coverage more affordable, with many NVCA members enjoying significant premium savings over what they’ve paid in the past.
The cost of betting that you won’t be sued and lose is increasingly high. Dealmakers are well advised to investigate the utility of insurance. “Insurance solutions in M&A transactions should be seriously considered. We’ve seen private equity clients use these coverages very successfully,” says Goodwin Procter’s Carl Metzger.
That’s good advice and, fortunately, there are increasingly attractive insurance options available to PE and VC firms to make taking that advise easier.
Pamela W. Mason, AAI, is management liability practice leader of Mason & Mason Insurance, specializing in risk assessment and coverage solutions in the areas of private equity and venture capital liability, corporate securities liability, directors and officers liability, portfolio liability programs, fiduciary liability and employment practices liability.