Clawback Woes Hit Battery and Meritech, With More Expected –

Venture firms are starting to really feel the pain from clawbacks. Battery Ventures in December laid off nine employees, including two general partners, as part of a decision to forego $51.4 million in management fees to offset a potential clawback on its fifth fund. Separately, Meritech Capital Partners’ limited partners have approved the firm’s proposal to waive about $45 million in management fees through the end its first fund.

The fee reductions follow TA Associates’ decision to return $38 million in late August to LPs in anticipation of clawbacks on three funds (see November VCJ) and Spectrum Equity Investors’ move in July to seek approval for a fee reduction on its third fund to offset an expected clawback of $27.5 million (see September VCJ).

Experts say they expect to see more firms take steps to deal with clawbacks. “I’m probably talking to about four or five venture groups that are potentially facing a clawback issue and are debating on how to address it, largely at the advisory board level,” says Paul Yett, a portfolio manager and principal for Hamilton Lane, which manages private equity assets totaling about $24 billion. “I wouldn’t be surprised if we saw 20 funds that were facing clawbacks.”

“Prior to a year ago, nobody was asking about clawbacks,” says an attorney who represents venture firms. “At this point, virtually every fund has done some analysis of whether they might have a liability.”

If a fund faces the possibility of a clawback, it should alert its LPs as soon as possible, Yett says. “It’s in the best interest of GPs to get all of this on the table sooner rather than later,” he says. “If we find ourselves having to litigate partnership agreements at the end of the life of funds, that is going to be messy. Everyone loses in that sort of situation.”

Jesse Reyes, vice president of Thomson Venture Economics (publisher of Venture Capital Journal) says the motivation of some firms to deal with clawbacks now rather than at the end of their lives in five or more years is not surprising. “These guys are jumping the gun on clawbacks to keep investors happy, because of all the uninvested capital out there and the management fee burden [that has been put on LPs],” Reyes says.

The fund-raising market is going to be very competitive when most funds are expected to go back out in mid-2003 and 2004, so GPs are reducing fees and the like to create good will with institutional investors, Reyes says. “They definitely know who’s writing the checks and who holds the power in these relationships,” he says, “and that’s the LPs.”

You won’t hear LPs complaining about receiving givebacks. “I personally think it’s a good thing [for VCs to take care of clawback liabilities now],” Yett says. “To whatever extent GPs can cure these positions today, it’s beneficial to the LPs and to the GP’s credibility.”

Some industry watchers speculate that there may be some personal bankruptcies as a result of clawbacks, particularly among young funds with first-time VCs. “I think it’s a real possibility,” Yett says. “I don’t think it will be prevalent; I don’t think we’ll see tons of individuals, but there will probably be a short list.”

The problem is that some GPs took distributions on a deal-by-deal basis when the market was hot, and rather than putting that money into an escrow account, they put it into the stock market, which went from boom to bust. Their personal net worth followed suit, putting them in a tough spot if a fund has to pay a clawback. If the GP can’t pay it, and the fund is set up in a way that the entire firm is responsible, other GPs could see their pockets emptied, or worse, end up filing for bankruptcy.

At least one attorney who works with top-tier VCs says it’s not an issue for his clients. “Our client base is primarily well-established funds, and as a result we haven’t seen any clawbacks rise to anywhere near that level [of potentially creating a personal bankruptcy],” says Steve Franklin, an attorney at Gunderson Dettmer who has been working with VCs since 1984. (Franklin co-authored a two-part series on clawbacks in the September and October issues of VCJ.)

In Battery’s case, the Wellesley, Mass.-based venture shop began reevaluating its finances and organization in August 2002, when it concluded that its $450 million fifth fund (which includes 1999’s Battery Ventures V and Battery Ventures Convergence Fund) likely would be hit by clawback provisions at the end of its life cycle in 2009. Rather than wait out the storm and hope for a miraculous rebound, the firm decided to preemptively take its medicine.

“We took a worst-case-scenario look at the clawback situation for our remaining [Fund V] portfolio, in which we assumed that all 15 companies go bust” says Tom Crotty, a general partner with the firm. “That would make the maximum theoretical clawback $44 million, and then we built in a bit of a cushion to deal with any technicalities that arise.” (The story was first reported on on Dec. 2.)

In order for the partial fee reduction to go into effect, Battery had to convince its LPs to ratify a partnership amendment sent out on Nov. 27. In exchange for the fee reduction, LPs would have to agree to eliminate the clawback provisions from the agreement. (VCJ was unable to learn the result of the LP vote before it went to press on Dec. 13.)

Fund V, which so far has returned approximately 50% of drawn-down capital, closed in 1999 with a 2.5% annual management fee and more than $13 million in committed capital from the general partners themselves. The firm began suspending Fund V management fees in June of 2001.

“If revenue is going to be down dramatically, which it is because we’re waiving so much in fees, then you have to look at the organizational element,” Crotty says.

Among the nine people Battery let go were general partners Tony Abate and Michael Darby. Abate joined the firm in 1999 to focus on telecom and Internet services companies like Cbeyond Communications LLC and Looking Glass Networks Inc. Darby signed on the following year to do communications and Internet infrastructure deals, like Black Storm Networks Inc.

Besides the two GPs, Battery let go of three venture partners, two back-office investment professionals and two operational employees.

“It may seem kind of strange for me to say this, considering that I’m one of the people leaving, but I feel they are doing the right thing,” says Dick McGlinchey, a venture partner who joined Battery in 1999. “They have spent a lot of time looking at various solutions, and this became their best option.”

While the management teams at Battery, Spectrum and TA have been open about their clawback situations, Meritech’s general partners declined to return repeated phone requests for comment. According to its Web site, Meritech is a “late-stage venture capital fund that was co-founded and sponsored by five leading venture firms: Accel Partners, Brentwood Venture Capital, Oak Investment Partners, Redpoint Ventures and Worldview Technology Partners. … [It] seeks to lead investments in later stage information technology companies from the Accel, Brentwood, Oak, Redpoint and Worldview portfolios.”

Specifically, Meritech “focuses on several technology sectors: wireline and wireless communications equipment and services as well as Internet-enabling technologies and components,” the Web site states.

The firm raised $1.1 billion for its first fund in 1999 and another $985 million in 2000 for its second fund. In the summer of 2002, Meritech’s LPs agreed to reduce the size of the second fund by 25% to $739 million.

VCJ confirmed through two sources familiar with Meritech’s situation that the firm reduced its fees to offset a clawback. In September, a super-majority of LPs of Meritech Capital Partners LP approved a proposal by Meritech’s general partners to waive about $44.5 million of management fees through the initial term of the fund, one of the sources says.

In return for the LP approval, Meritech’s general partners get a dollar-for-dollar reduction in any possible clawback obligation when Fund I comes to the end of its life on Sept. 30, 2005, the source says.

The particulars of the fee cut are as follows: Starting on July 1, 2002, annual management fees were reduced from 1.5% to 1.35%. Then, as of Oct. 1, 2002, the annual management fees (totaling $14.85 million per year) were waived through the remaining three years of the partnership.

Since it was formed, Meritech’s first fund has invested in at least nine companies that have gone public, including Avici Systems Inc., Corvis Corp.,, and MetaWave Communications Corp., according to Venture Economics. In addition, another half dozen of its portfolio companies have been acquired, including, OneBox Networks and Telera Inc., according to VE.