While everyone knows life is not always fair, in today’s world it is almost as much of an established fact that when something goes wrong, someone is likely to go to court to make it right. For the last few years it seems as if everything has been going right for the venture capital market, venture capitalists and entrepreneurs. Everyone made lots of money and that made everyone happy.
But now the bubble has burst, the initial public offering window is nailed shut and VCs are talking about becoming more frugal with their dollar. Times are changing, which might strike some as unfair. It is this feeling of being wronged that can lead to law suits. Although there has not yet been an explosion of litigation concerning the wave of “dotbomb flameouts,” lawyers say the possibility of legal action is real. “Some companies in the last venture capital market [cycle] seemed to gestate quicker than usual and the faster the process goes, the greater the potential for problems,” says John LeClaire, co-chair of the private equity/emerging companies group at the Boston-based law firm Goodwin, Procter & Hoar LLP.
VCs, as a group, seem a little less concerned about the possibility of potential lawsuits that actually have merit than private equity lawyers do, but they are not dismissing the notion of legal problems out of hand, either. “There is nothing you can do to protect yourself against frivolous law suits,” says Stacey Anderson, managing principal at Charlotte, N.C.-based Piedmont Venture Partners. “But if you do what is right, you should be okay,” she adds.
The question confronting VCs, then, is two-fold: What issues should they be looking out for? What is the right thing to do to avoid legal troubles from these potential pit falls? The answers are important, because as LeClaire points out, VCs do not make the most sympathetic defendants in a state courthouse. “Many of them are young and rich and they have real power over real jobs,” he says.
Weathering a Down Round
As the VC market mirrored the frenetic climb of the public markets, private company valuations soared, and neither VCs nor entrepreneurs ever envisioned down round financings. In today’s market, down rounds, their more nefarious sibling inside down rounds, and the resulting dilution of ownership are a fact of life in the venture world. “In venture capital, dilution, dilution, dilution are the three rules, and founders have to get ready for more of this,” says Joseph Bartlett, a partner in the New York office of law firm Morrison & Foerster LLP.
“In the next six-months, I think there will be a lot of down rounds,” says John Egan, III, senior corporate partner and head of private equity/emerging companies practice group in the Boston office of the law firm McDermott, Will & Emery. The potential legal problem represented by down rounds is not the often considerable pain involved in completing one, but, oddly, in the event that the company rebounds from the down round and becomes successful, leading disgruntled shareholders to challenge the prior financing. “If a company does rebound, you will see people coming out of the woodwork, saying You diluted me and I should have a bigger piece of the equity’,” he explains.
Inside down rounds, where some or all of a company’s existing investors participate in the funding, present the additional hurdle of possibly being contested by common stockholders as a self-dealing transaction, LeClaire says. This charge alleges the transaction was set up by existing investors through their representatives on the company’s board to increase their percentage ownership in the company at a favorable price. This dilutes the position of the founders and other common stockholders of the company, who may later allege that the transaction was approved in breach of the fiduciary duties of the VC’s director-representatives or even the VC funds themselves, LeClaire says.
Preparation is the Best Defense
The way for VCs to proactively prepare for these potential challenges is to focus on having a reasonable process in place, McDermott’s Egan says. To begin with, in the event of a down round the company and its investors should always try to find outside investors that are willing to lead the down round, he says. “If the company and the VCs tried to get other funding and could not or got it at a lower valuation, I think this is good evidence that what happened is okay,” he adds.
If outside investors cannot be found, Egan says the existing investors should bring in an investment banker or other outside expert on valuation, to set the price for the new round. Another important step to take in the event of an inside down round, is for VCs to recuse themselves as directors, he says. “VCs should not make decisions as directors here…the company and its independent directors, should negotiate with VCs about the terms of the deal,” he notes.
A final part of putting a solid, reasonable process in place is making sure a company’s board minutes are thorough, but not overly detailed, LeClaire adds. “[The minutes] should document that the board did what it should do, without leaving a lot in the minutes that can be questioned later,” he says. “This is a matter of documenting that the process was exhaustive, but only leaving in the outcome and not the analysis which generated that outcome.”
A number of VCs agree with Egan that the best possible protection from subsequent challenges to down or inside rounds is to bring in an outside investor, because either the new lead determines a company’s valuation or the inability to find a lead indicates that a down round is necessary. “Whenever we are involved with a company that is going through an inside round or a down round, we first let the company go out to market and see if it can find any other money,” says, Stuart Ellman, a general partner at RRE Ventures. “That way the VCs do not determine the price, the market does.”
Other VCs say the way to avoid accusations of self-dealing is to simply make a rights offering to all the company’s shareholders. “If there is a down or inside round, it is important to give everyone who already invested in the company the opportunity to invest in the down round,” says H. Dubose Montgomery, a managing director at Menlo Ventures. “Because later on if there are any problems you can say, Hey, we gave you the opportunity to participate’.” Extending a rights offering to all of a company’s shareholders is not always a viable option, notes Egan. There is always the potential that some of the company’s shareholders may not be accredited investors, he says. This means a company would have to provide full financial disclosure forms to potential investors in order to qualify for safe harbor provisions under federal securities law, he adds.
Wait Until You’re Committed
As the VC marketplace slows down from the fever pitch it had reached early last year, Egan says there could be an increasing focus on letters of intent. Some five years ago VCs did not send companies letters of intent until the deal was done, he says. In the fast pace of the recent past, some VCs seemed to be using letters of intent to slow down fast moving companies in which they were considering investing, he adds. “I think entrepreneurs will put more emphasis on letters of intent and will expect that after receiving a letter of intent they will also receive financing,” he adds. “Because in today’s environment it could be the end of the road for a company if they get a letter of intent and then the VC decided not to do the deal.”
The potential legal issue for VCs surrounding letters of intent is if they back out of a deal after sending a company a letter of intent. The company might bring legal action and argue that the letter of intent’s no-shop provisions prevented the company from seeking funding elsewhere, while the market has passed them by and their company is dead before it got off the ground.
The smart way to try and avoid this is to have a non-binding letter of intent that carefully spells out its critical terms and conditions of the impending due diligence process, Egan notes. The letter should also include language that says if the letter of intent is breached, the VC will only be liable for a company’s out of pocket costs, he adds. “Nobody says this is totally enforceable, but it is better to have than not,” he notes.
Some VCs were skeptical as to whether or not this was an issue that actually merited much concern. To begin with, a certain portion of the VC community just does not bother with letters of intent. “We do not use letters of intent,” says RRE’s Ellman. “We do our due diligence, do our work and then when we are ready to do a deal, we send out binding term sheets, because without a binding term sheet, you don’t have a deal.” Menlo Ventures also eschews the use of letters of intent, says Montgomery. “Our view is, if we talk with a company about doing a deal and they also want to talk with others about financing, that’s okay,” he adds.
Issues surrounding letters of intent come down to ethics, says Piedmont’s Anderson. “Was the letter subject to due diligence? Did management agree to this? Did you include material adverse change provisions? If so, you should be fine,” she says. Another VC agrees with Anderson, noting that a quality letter of intent and honorable behavior should be enough protection for a VC. On the other hand, he says that suing a VC firm for backing out of a letter of intent may not really help a developing company achieve its actual long-term goals. “So sue me. If you do this, it is not like you are going to get financed by anyone else,” this private equity investor says.
Control and Liability
LeClaire says it is important for VCs to be aware of the fact that the whole drift in the law has been to tighten the relationship between a company and its board of directors. This trend could potentially lead to what Egan termed increased control person liability issues. This is a situation in which an individual or a fund can be held liable as a control person for a breach of fiduciary duty. A possible example of this would be when a VC, who is also a director of a company, helps recruit someone for a key management position in that company that subsequently encounters difficulties and perhaps even shuts down. A possibility exists that the manager the VC recruited could bring a suit arguing the VC knew of these problems and was not up front about them in the recruiting process.
VCs who are directors of companies should make sure the companies indemnify them in anything the VC does on behalf of the company, to protect the VC against the possibility of law suits. “This means that the company will have to stand behind the VC,” he notes.
VCs say Egan’s example seemed unlikely. “This sounds pretty far-fetched to me. After all, it is a private company, which is high risk/high reward and can change in a heartbeat,” says Rick Kimball, a general partner at Technology Crossover Ventures. Rather then being an issue that requires special protections, VCs argued problems of this nature could simply be avoided by fair dealing. “I am always going to be open, honest and honorable,” says RRE’s Ellman. “So I will recruit for a company, but I won’t be facetious about a company’s situation.” Another VC agrees with Ellman. “As long as you operate according to accepted fair business practices, you are good to try to build value and not worry about covering your own ass,” the VC says.
Most VCs seem to believe that in the end the best prevention of and defense for legal troubles is to behave in an appropriate and scrupulous manner when going through the deal making process. Ellman says RRE takes the position that every decision it makes should be able to be held up for public inspection on the front page of The Wall Street Journal. However, being aware of potential legal pratfalls and protecting yourself against them in advance is something that should be on the mind of every VC, lawyers say. LeClaire notes, “the venture process is not over until your investment has been liquidated and you have not been sued.”