Cover Story: With Companies Faltering, VCs Look at Redemption Exit –

Eighteen months ago, a venture capitalist’s choices were much simpler – when to go public, at what price to set shares, and then, how much profit to take after the lockup period.

Now, a down market is forcing VCs to make quick, often uncomfortable decisions as the cash in many of their portfolio companies is running out.

In most cases, when a VC concludes a company is failing to reach its objective, his first reaction is to pawn off the company on a strategic buyer. If that option crumbles, the insolvent company usually winds down to the last dollar, sometimes filing for bankruptcy.

However, in a few cases, VCs have avoided a painful wind-down by identifying a dying portfolio company in time to seek an early redemption and liquidation of its assets before the cash is depleted.

“If there isn’t a business here, [you can accept it, or] you can spend all your money and prove it 18 months from now,” says Richard Couch, chief executive officer of Diablo Management Group, a turnaround and wind-down consultant. “[Early redemption] is a smart move. It doesn’t happen nearly enough.”

One might think that after the meltdown in Internet stocks, more VCs would consider this strategy. But, early redemption is an embarrassment, as if employing the strategy effectively admits defeat. And even for those who desperately want to redeem out of an investment, the terms of the deal may prohibit them from doing so.

But there’s no question that for those VCs who have negotiated an early redemption, the practice has saved them considerable time and money. And with exit options more limited these days, it’s looking like a more attractive option.

Calling it Quits

“If you wouldn’t have funded this idea had it come to you today, it doesn’t make sense to continue,” says Jonathan Slater, a serial entrepreneur. “You might as well call it quits and go home.”

At least two VCs said they were involved in early redemptions but were reluctant to offer details. Couch estimates he has heard of five or six redemption cases.

For example, the press has widely reported that Kibu Inc. and Great Entertaining Inc. chose redemption, ceasing operations before reaching the ugly, final implosion. According to our VentureXpert database, Kleiner Perkins Caufield & Byers, Allen & Co. and Helix Investments Ltd. had backed Kibu, a teen-targeted Web site. They reportedly liquidated the company for about a third of their original investment.

Investors in Great Entertaining included Benchmark Capital, Technology Crossover Ventures, Infinity Capital LLC and Attractor Investment Management. (Attractor declined to comment for this article, and no other firm, except for Infinity Capital, in either deal responded to phone calls on the subject.)

Virginia Turezyn, managing director of Infinity Capital, says with Great Entertaining “an experienced board that had been through the upsides and downsides” recognized that the online party-supply outlet could never get the critical mass needed for success.

Taking an honest look at its prospects, the board and management agreed that the best decision was to cease operations. “Rather than sticking with something that doesn’t have the ability to strive and survive, it’s better to move on,” Turezyn says. Even though the investors did not get much, if anything, out of the redemption, she says the company made good arrangements with the employees and creditors.

“I commend the management team fully” for being honest and realistic, she says. “The true mettle of an individual is apparent in the tough times. This founder is someone I will work with in the future both of the founders.”

Soothing the Egos

As odd as it sounds, liquidating the company is probably the least painful scenario leading to an early redemption. Strong emotions and egos tend to threaten the possibilities of this mutual agreement, but it makes a less-negative outcome much more likely.

“[The agreement to redeem] requires exceptional maturity and discipline,” says Couch, who recently worked on a redemption case. “Early on, the management knew the risks and set criteria” to measure their possibilities for success. An early conversation was, “How would you know it wasn’t going to work?”

Entrepreneurs are very passionate about the business, and when management still legally controls the company, the VCs have to persuade management into accepting redemption. The conversation could go two ways: explosive disagreement or a mutually agreeable winding down. Slater says the entrepreneur’s reaction will determine which conclusion is met and will depend on how the VCs make their case for redemption.

“The context of that first approach will dictate the results of the future resolution,” he says, encouraging VCs to handle entrepreneurial egos with kid gloves. The possibility of future support might be an incentive to accept failure, because whether they’ve just won the war or lost their army, every good entrepreneur feels like they have another battle to fight.

Forcing the Issue

If management will not concede failure, VCs may be able to force them into redemption. Most term sheets include redemption clauses, but Jeff Clopeck, partner at Day, Berry & Howard LLP, says redemption is the “most unlikely” outcome. In many instances, VCs cannot exercise their contractual redemption options for up to five years.

Ken Boger, partner at Kickpatrick & Lockhart LLP, says VCs added these “walking dead provisions” as a means to force control of a company that will never achieve its original expectations or go out of business under its own weight. By the time VCs can exercise these clauses, the invested capital is often gone, and there is nothing left to redeem.

Although these lawyers say the actual redemption clauses are just disguised control mechanisms without any real financial motivation, VCs may be able to force redemption earlier in the company’s life through other means.

Doug Chertok, managing director and general counsel at Hudson Ventures, says he usually includes a term in the documents that states any material breach of any representations or warrants in the stockholders’ agreement or of any other covenants will result in the last investors gaining simple majority board control.

Depending on the structure of the stockholders’ agreement and the board, VCs can also sometimes back into control of the board through a VC-friendly outside CEO or “independent” board member. In either case, the investors with board majority may be able to force liquidation.

Michael Littenberg, corporate partner at Schulte Roth & Zabel LLP, represents parties on both sides of the table, and he calls these control negotiations “the dance.” When his client calls him with a request outside the client’s contractual rights, attorneys representing each side of the disagreement get on the phone.

Littenberg says they use concessions and pressure points to dance around the technical provisions of the contract and to force the desired issues. Chertok’s material breaches would come into play here to force control, but Littenberg says management has resisted control in cases where no contractual right existed leading to a very ugly breakdown in the relationship between the board and the management.

Benefits of Closing Shop

In the end, the opportunity cost of the time spent winding a bad deal down and scrambling for a merger might be the biggest potential benefit of early redemption.

“If you look at the math, there’s a pretty compelling argument that when it becomes apparent a company won’t reach its objective, a senior partner should put a junior partner on the deal,” Couch says. “There are a surprising number of cases where the venture guy would be better off assigning a lower priority to the business.” He says the switch may hurt the relationship, but he knows several prominent VCs who pass their long shots to workout specialists and junior people in the firm.

Limited partners require their funds to score big wins, so it’s easy to see why general partners would rather focus their energies on looking for the next America Online rather than fixing broken widgets. Along those lines, maybe the whole firm is better off cutting their losses on deals with no hope of success.

“If you’ve got a company that is terminally ill, you could go through a lot of heroics to find a buyer,” says Tom Simpson, managing partner at Northwest Venture Associates LLC. Simpson adds that VCs commonly underestimate the time needed to close a sale, and all the time and money sown in the process may reap nothing in the end.

“If [the companies seeking acquisition] don’t have somebody who has approached them already, we tell them to prepare for a four- to six-month process,” says Bob Cronin, managing partner at Stonebridge Technology Associates, a boutique investment bank. “It becomes harder to get a deal done when the other side realizes you’re running out of cash.”

Moreover, VCs will preserve their reputations and relationships much more effectively through this downturn if they have the capital left in their portfolio companies to settle debts with creditors and employees.

Liquidation also establishes a value for the company more firmly than if it lingers on the edge of death for several months. The fund can materially establish a tax loss and, for better or worse, write the company off its portfolio. Nobody likes a write-off, but the sooner VCs chase the dogs off the books, the sooner people may forget about them. In some cases, early redemption can help the return, albeit slightly. VCs aren’t in the business to pinch pennies, but a 70% loss hurts less than a total loss.

When the window of hope remains even slightly open, these arguments for redemption don’t find much traction with most VCs.

“The investor believes in the diving catch in the end zone, but they don’t give themselves any contingency plan,” Couch says. By the time he gets involved, companies have often eliminated most of their options, and Couch estimates that only about 10% of the troubled deals he has seen ever returned any money to the investors, let alone a profit.

Fiduciary Stumbling Blocks

“If I were a venture guy with a portfolio of losing companies, I would be interested that the most I lost was the money I put into it,” Boger says. “It’s one thing to lose your money, but it’s another thing to lose your money plus end up on the other side of a lawsuit.”

Couch started working on his recent redemption case by negotiating settlements with every creditor and getting full releases. The company then paid employees, payroll taxes, the 401(k) pool and the insurance bills. After all the obligations were met, the company repaid its investors about 20% of their invested capital.

Usually, “it doesn’t work very well,” he says. The decision comes too late, and by that point, VCs sitting on boards have fiduciary responsibilities to three conflicting interest groups: their LPs, other company shareholders and the company’s creditors.

“Members of the board have a primary fiduciary responsibility to creditors when a company is technically insolvent,” he says. Insolvency can happen before the company files for bankruptcy. Because equity holders often handle this responsibility poorly, Couch recommends bringing in new counsel specializing in bankruptcy and restructuring.

Some boards have erroneously paid off their cronies in advance of other creditors – a practice known as insider preference. Couch says companies also fall into traps with severance pay. They have the legal responsibility to pay employees for time worked and accrued vacation but not severance. Couch doesn’t advise paying severance, (which he calls other creditors’ money), because creditors hate taking a haircut so a company can needlessly pay the employees to leave.

Littenberg says conflicts even exist between shareholders. “Not all VCs have the same interests,” he says. Board members have fiduciary responsibilities to all shareholders, which can get sticky with early investors and strategic VCs.

An Unlikely Outcome

In any event, most venture players still view early redemption as an unlikely occurrence. Jay Hachigian, founding partner of Gunderson Dettmer says, “If the business plan is not a viable plan, [the company] is either going to be sold or shut down.” He does not think early redemption and liquidation is often a possibility.

John Egan, corporate partner at McDermott, Will & Emery, says the trend of companies redeeming out is not significant, because most companies just hit the wall and fail.

Talking with VCs would lead someone to think that most of their dogs end up getting sold off to other companies, and reading the papers might lead someone to think bankruptcy is the most common end. Both results happen more often than an early liquidation.

VCs are “in the business for multiple returns, not in the business to get their money back,” Boger says. “Most of the time the venture guys aren’t going to have the luxury of redemption.” He calls it a Catch-22: By the time they lose confidence, the money is gone.

Couch says he got involved with a company negotiating for a last ditch sale at a $100 million valuation. He says everybody – management, the board, and outsiders – knew the company wasn’t worth that much. The company had $10 million left, and everybody knew the deal would fail. But they just wouldn’t admit it.

The company was burning through $4 million a month, to preserve the pretenses of solvency during the sale negotiations. After 60 days, the sale fell through, like everyone knew it would. The company couldn’t make payroll for the next month, and they called in Couch.

For that company to continue to try the diving catch in the end zone made no logical sense. Early redemption and liquidation would have likely saved the VCs money and saved the entrepreneurs the heartache of a fiery crash. However, this example is the rule to which early redemption is the exception. So, why do so few VCs and entrepreneurs in obviously troubled companies accept reality and close shop sooner?

“These are smart people,” Couch says. “But, these people are in love.”