Epinions Suit Raises Fears of More To Come –

Tongues are wagging more than usual on Sand Hill Road.

The hot topic of conversation? A lawsuit against Silicon Valley venture firms August Capital, Benchmark Capital and BV Capital. The suit was brought by co-founders and former employees of a dot-com who claim that the VCs cheated them out of millions of dollars. Adding drama to the case, two of the plaintiffs have themselves been venture capitalists. One still works at a valley firm and another spent part of his young career as an investor at one of the firms named in the suit.

It’s uncommon, shocking even. But the same scenario is going to happen again, and probably sooner than Silicon Valley expects. In fact, a similar suit filed by a startup founder against two other valley VCs was recently settled to the satisfaction of the founder.

The aura of invincibility that has long protected venture capitalists-along with their generally keen intellect, their deep-pocketed firms and their attorneys-has been dissipating over the last few years. The latest suit may mostly serve to pop this already deflating bubble.

“No one expected this situation to go as far as it has, but it’s sort of part of the Eliot Spitzer effect,” observes Paul Kedrosky, who teaches business and entrepreneurship at the University of California at San Diego. “There’s a lot more sympathy for entrepreneurs than there might have been a couple of years ago. People are more willing to take their chances that a jury might sympathize with a founder who has been wronged by an investor or a board member.”

Litigants may be emboldened by the recent settlement of a similar suit that made harsh allegations against venture capitalists. Aamir Latif, a serial entrepreneur who founded Nishan Systems in San Jose, sued Lightspeed Ventures, ComVentures and others in 2003. His suit alleged that the VCs saddled him and Nishan’s approximately 100 employees with onerous terms that ensured the VCs received most the $85 million for which they sold the company to Colorado-based McData. Latif’s attorney, Rony Sagy, says the case was recently mediated. The settlement terms were undisclosed.

The suit against August, Benchmark and BV similarly centers on the profits they made from the sale of a company they helped to build: Epinions. The plaintiffs include three of Epinions’ five co-founders: R.V. Guha, today an IBM researcher; Mike Speiser, currently a vice president of product marketing at Veritas, and Naval Ravikant, who until recently was a VC at Dot Edu Ventures, which he joined after a stint as an investor at August.

The three are joined by 40 former Epinions employees, including Kevin Laws, a principal at PacRim Ventures and a frequent contributor to VentureBlog, which was launched by partners at August last March and remains a standard-bearer of the fast-growing venture blog genre.

Also named as defendants in the suit, which was filed in Francisco Superior Court, are Epinions co-founder and former CEO Nirav Tolia, and Shopping.com (NASDAQ: SHOP), created by the merger of Epinions with another startup, DealTime.

Ravikant and the others claim that the defendants-including Epinions board members Bill Gurley of Benchmark, John Johnston of August and Thomas Gieselmann of BV-told them that their ownership stakes were worthless but at the same time the Epinions’ board was promoting Epinions’ merger with DealTime. Convinced that Epinions would fail without the deal, the plaintiffs claim that they allowed their common shares in Epinions to be valued at zero, only to watch the VCs and Tolia (who unlike the plaintiffs, remained at the combined company) reap tens of millions of dollars when Shopping.com went public in October 2004.

“The board of Epinions took its fiduciary responsibility very seriously,” says Benchmark Operating Partner Steve Spurlock. “It conducted merger discussions with six potential acquirers, and the company sold to the highest bidder.” Spurlock further says the “suit is completely without merit, and we will defend it vigorously.”

It could be a long battle. One person familiar with the matter says that the VCs “won’t settle. They’ve been called liars. They see this as a moral war, and they can outspend [the plaintiffs] if need be.”

A number of developments have conspired to change the power balance. For one thing, financial services firms, insurance giants and music publishers alike have been publicly flogged for unethical behavior and made to make financial amends to wronged parties, thanks to efforts of people like New York State Attorney General Eliot Spitzer. Seeing the windfalls that some of those suits have produced, some people may feel more confident about suing for rights that they feel have been violated.

For another, not all suits against the venture capital industry die, despite efforts by their attorneys to paper petitioners to death. San Francisco’s Hummer Winblad Venture Partners is still facing lawsuits from Universal Music Group, EMI Music and other music-publishing companies over its stake in the now defunct Napster file-sharing service. (Bertelsmann, the German media conglomerate, also remains entangled in related litigation owing to its one-time role as a Napster investor.)

As it happens, many who sue pay the price for fighting, including, often, in the form of ambivalence on the behalf of peers. The reality is that to a large extent, both VCs and entrepreneurs alike accept that tough liquidation preferences are the price that many founders must pay in order to see their companies survive and, hopefully, thrive.

Dion Lim, an Epinions’ co-founder and serial entrepreneur who chose not to join the suit, says: “I left the company [Epinions] very early in the heady days of the Internet to pursue some additional ideas with my wife [including the now defunct incubator, Simians.com, and shuttered online advertising startup Bannerama]. While I am proud of the hard work I contributed early on in the company’s life, I believe that the team which stayed and worked hard through some very rough times is very deserving of the reward they received.”

Lim did not respond to a query about whether he possessed common shares of Epinions at the time of the DealTime merger, which would have put him in the same boat as the three co-founders who are suing.

“Sophisticated entrepreneurs know how the game is played,” Kedrosky says.

The price of taking on the clubby venture capital world is experienced in less subtle ways, as well. Roughly one week after the Epinions suit was filed, Ravikant was nudged out of Dot Edu and his profile on the firm’s website was quickly removed.

Ravikant did not return messages seeking comment, but Dot Edu’s managing partner, Asha Jadej, says: “We were at a point where we felt there were multiple factors, including the suit, which helped us all decide that this might be a good time to part ways.”

The partners at Dot Edu likely could have been thinking about whether having Ravikant on their team would hurt their relationship with August and Benchmark. Dot Edu has invested alongside August in at least two companies: NeoPath Networks, a network file management startup based in Santa Clara, Calif. and Mimosa Systems, an email management software developer based jointly in Santa Clara and Pune, India.

At NeoPath, Ravikant is listed as a member of the company’s “business advisory board,” while August’s Vivek Mehra sits on the board. Mimosa’s website lists Ravikant as a board member along with August co-founder Dave Marquardt.

The Dot Edu team may also have been thinking about thorny questions that could come from limited partners about the suit. The Palo Alto, Calif-based firm’s first fund (a $20 million vehicle raised in 2000) is close to being fully committed, and the firm is believed to be out fund-raising. Surely, making a presentation to a potential LP who is already an investor in August or Benchmark would be more challenging provided Ravikant’s role with the firm.

PacRim may face similar questions if Laws continues with the firm. It raised its inaugural, $25 million, fund in 1999. Managing Partner Tom Toy declines to address whether PacRim is raising more money this year, offering instead that his firm is still deploying the fund at hand.

In the meantime, Ravikant and the others are seeking, through a jury trial, “disgorgements of defendants’ ill-gotten gains,” reads the complaint, and damages in the amount of the current value of the equity interests in Epinions that they held before the merger.

They may lose. In a sense, though, they have already won. Despite investment opportunities that are once again plentiful and despite the fact that capital continues to flow to new venture funds, venture capitalists, long the musclemen of the New Economy, have now been painted as bullies by the suit. Surely, the case will not be the last they see, either.