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Beware a New Wave of Litigation

It’s been roughly four years since a spate of VC-targeted lawsuits over dilutive financings set tongues wagging in Silicon Valley, and the same scenario is going to happen again—possibly sooner than Silicon Valley expects.

“I’m already seeing some activity and working on things right now that involve down-round financings,” says Michael Sullivan, an attorney in the San Francisco office of law firm Howard, Rice, Nemerovski, Canady, Falk and Rabkin. “There’s growing evidence that the market is creating potential for litigation.”

“I’m hearing lots of chatter about coming lawsuits in cleantech,” adds Paul Kedrosky, a senior fellow at the Kauffman Foundation. “There’s a huge overhang of deals needing to get done, at a low fraction of what investors want to pay. Given the capital requirements and that [VCs] have to do these financings or get crammed down, we’ll see it [in cleantech] first.”

One of the highest-profile lawsuits in recent times was against Silicon Valley venture firms August Capital, Benchmark Capital and BV Capital in early 2005. The suit was brought by co-founders and former employees of the dot-com startup Epinions, who claimed they’d been cheated out of millions of dollars by their venture backers, who they accused of valuing their shares at zero while simultaneously discussing a merger with another startup, DealTime. The combined company, renamed Shopping.com, went on to enjoy a highly successful public offering in October 2004.

Whether the case might embolden future litigants is unclear. The case was resolved, but the terms weren’t publicly disclosed. “As part of the resolution of the Epinions matter, we agreed not to discuss the case,” says Benchmark General Partner Bill Gurley.

Still, given the glut of dilutive financings that has taken place again of late, a gradual if small wave of litigation seems more likely than not. Fully 75% of venture-backed companies that secured follow-on investments in the first quarter did so at flat or lower valuations than in previous rounds, according to the Fenwick & West Venture Capital Survey released in early June. The industry hasn’t seen so many down rounds—which accounted for 46% of all first-quarter, follow-on financings—since the first quarter of 2003.

There’s growing evidence that the market is creating potential for litigation.”

Michael Sullivan

A meaningful percentage of first-quarter transactions—about 14%—also involved “pay to play” provisions, in which existing investors who don’t participate in follow-on rounds may see their stakes diluted or their preferred shares converted to common stock. It’s that number that’s giving VC attorneys pause.

“Litigation is largely theoretical at this point,” says attorney Steven Franklin, who co-founded the law firm Gunderson Dettmer and heads its venture capital and private equity groups from Redwood City, Calif. “No one spends money on a washout financing unless the company in question is turned around and makes money.” Which is precisely when the trouble begins.

“A lot of times, you either do a down round or go out of business,” says Franklin. “But it’s very easy in hindsight [for common shareholders of a turned-around company] to say, ‘You were taking advantage of shareholders who had no money.’ It’s why now is a good time to think through the implications.”

One step to take—perhaps the first step—is to shop the financing, as well as to keep a very clear record of the company’s attempts to obtain financing from other investors at the best price. “Even if it winds up being purely an inside round, you then have proof that [the round] was a last resort done on economically equitable terms because you tried to get better terms and were unsuccessful,” says Franklin. “If 12 other investors turn down your deal, it helps to refute any later claims that you must have known [a company that later gets turned around for a profit] was a great investment.”

Another smart move is to extend a broad rights offering, or issuing rights to the company’s existing shareholders to buy a proportional number of additional shares for a fixed period at the same price that VCs are paying for the new, discounted, stock.

Likewise, attorneys advise getting a majority of disinterested directors to approve the diluted financing by enlisting those board members who don’t represent management and aren’t planning to re-up. “A common critique of these deals is that they’re insider deals,” says Sullivan of Howard, Rice. “They’re much easier to uphold if you’ve assembled a committee of parties who aren’t participating in the deal going forward or in control of the company and whose jobs may depend on the financing.”

It’s very easy in hindsight to say, ‘You were taking advantage of shareholders who had no money.’ It’s why now is a good time to think through the implications.

Steven Franklin

A trickier measure to pull off is to seek a release from stockholders via a signed waiver stating they won’t sue over what may later appear to have been a good valuation. It’s “very difficult” to enlist everyone, says Franklin, but he says it’s worth a shot.

Carl Metzger, a partner in the Litigation Group of Goodwin Procter, agrees. “You might go to them and say, ‘I’ll put in money and keep this company alive, but you have to waive any claims against me in connection with this financing or I’m not putting in the capital, the company will go out of business, and you’ll get nothing,” he says.

Naturally, the best measure of all is ensuring that everyone is treated fairly. VCs invariably say it is one of their overarching goals at all times. “As a firm, we have always been, and always will be, fair in how we finance companies,” says August Capital General Partner David Hornik. (Like Gurley, Hornik says he can’t speak about the Epinions suit.)

Even so, it’s worth thinking about what fair treatment entails. “If you’re dealing with institutional investors,” says Franklin, “they don’t need a lot of face-to-face meetings.” When it comes to common shareholders who are less sophisticated, on the other hand, it is helpful to communicate as much possible with them about what the impact of the financing will be.

Franklin even suggests Q&A sessions to help them understand what their options are. The sessions may not do much legally, but, as he observes, “It’s when people feel abused that they file lawsuits. If they can say, ‘I was told what was happening and I made the wrong choice,’ it’s much easier for them to move on.”

Most firms have already grown smarter about how they conduct down rounds since earlier in the decade, when several suits besides Epinions made harsh allegations against venture capitalists. Another notable case was brought by Aamir Latif, a serial entrepreneur who founded Nishan Systems in San Jose. Latif sued ComVentures, Lightspeed Ventures and others in 2003, alleging they saddled him and Nishan’s approximately 100 employees with onerous terms that ensured the VCs received most of the $85 million for which they sold the company to Colorado-based McData. That case was later settled for undisclosed terms.

You might go to them and say, ‘I’ll put in money and keep this company alive, but you have to waive any claims against me in connection with this financing or I’m not putting in the capital, the company will go out of business, and you’ll get nothing.”

Carl Metzger

The bad news is that while the risk of being sued may be minimized, it is impossible to eliminate it altogether.

“We’re being very proactive,” says Sullivan. “These days, when we participate in a down-round financing, we go to great lengths to explain the risks involved and try structuring the deal according to what are becoming the established guidelines: Making an offering pro rata, making sure you kick the tires with outside investors and getting the approval of disinterested board members and shareholders.”

Still, says Sullivan, “sometimes you just can’t get there.”

“These claims don’t happen at the bottom of the market,” adds Franklin. “They happen when a company has resurrected itself and there’s something at stake. That’s when disappointed shareholders say: ‘You shouldn’t have diluted me two or three years ago.’”

In short, he suggests, stay tuned.