Recent sexual misconduct and harassment claims have sparked understandable distress among venture investors and their LPs. They’ve also exposed a hard truth: the industry is far from prepared to deal with the aftermath.
Limited partner agreements have clauses for removing offenders and winding down funds. Yet using them is difficult and LPA terms can make finding the money to manage a fund’s remaining assets a hurdle. This is unlikely to change right away.
The industry’s condemnation of the behavior of Justin Caldbeck at Binary Capital and Dave McClure at 500 Startups was swift and universal.
“You shriek with horror and disgust,” said Greg Bohlen, a managing general partner at Union Grove Venture Partners. Venture capitalists are aggressive by nature, but investors want them to apply that aggressiveness to getting companies into the portfolio, Bohlen noted.
LPs and GPs also fear other shoes will drop, that more bad behavior is waiting to be exposed.
“This is just the tip of the iceberg,” said one VC insisting on autonomy. “The industry is going to have to clean up its act.”
Some VCs have called on LPs to help do just that. Reid Hoffman of Greylock Partners posted such a call to arms late last month, writing in a blog post that “any VC who agrees that this is a serious issue that deserves zero tolerance – and I certainly hope most do think this way – should stop doing business with VCs who engage in this behavior. LPs should stop investing.”
The cry was echoed by Brad Feld, a partner at the Foundry Group, who claimed on the firm’s website that not enough has been done to combat sexual harassment and sexual misconduct. Feld announced that Foundry would enforce a “zero tolerance” policy for its investments as an LP in other venture funds through its Foundry Group Next fund.
“Any allegation of sexual harassment by an employee of a fund we are an LP in will result in an immediate investigation, with a goal of having it resolved as promptly as possible,” he wrote. “If the harasser is a GP, we will ask for the immediate resignation of the harasser and, if refused, we will engage with other LPs to explore legal removal of the harasser.”
LPs have a duty to confront this issue, he added.
Trouble is, doing so can be a challenge. LPAs are not entirely up to the task.
This is in part because LPs can struggle with how to pay a caretaker after a GP or investment team is removed. Often GPs removed from a fund walk away with a good part of their carry intact, making it hard to find the money to pay a successor.
LPs also can have trouble marshaling the required number of investors to remove a GP.
The reason is that the LPA clause most probably used to push aside a GP for sexual misbehavior is the no-fault clause and not the GP removal clause. No fault, as it states, gives LPs the right to dismiss a general partner without wrong doing, while the GP removal clause requires a bad deed, such as fraud or embezzlement. The GP removal clause typically has a provision for misconduct, but misconduct is a vague term hard to pin down in court, attorneys say.
The result of this uncertainty has LPs relying on the no-fault clause.
This in turn creates bigger hurdles since the no-fault clause requires broad agreement among LPs, and limited partners often don’t have exhaustive lists of co-investors in a fund to contact and build consensus. Typically 70 percent to 80 percent of the financial interests in a fund need to back a no-fault removal. Only about two-thirds is necessary for a GP removal.
But it is the economics attached to each that is most critical. With a GP removal, the offending GP’s interest in a fund will be cut in about half. With no fault, the GP can retain 80 percent of his or her financial interests. LPs have no mechanism for clawing back this value and therefore little of the fund’s finances to pay an outsider.
Clearly, “in a typical limited partner agreement for a standard venture capital fund, LPs acting collectively may have the capacity to remove a general partner for cause or not for cause,” said Murray Indick, a partner at the law firm Morrison Foerster.
But the reality is, it is not always a smooth path. “It’s very difficult when you make an investment to be part of a wind down,” Bohlen conceded. “It doesn’t happen often. When it does, it makes headlines.”
This means halting capital calls, ending management fees and bringing in a caretaker to manage or liquidate a fund. Other provisions of the LPA, such as the key-person clause, also come into play to sort things out, generally leading to complex negotiations.
“These are escape hatches for LPs, but they are most often used as leverage over a GP,” said Michael Kim, a managing partner at fund of funds Cendana Capital, referring to the negotiations. “That’s how they are wielded.”
Negotiations, indeed, have been the case at Binary, where Caldbeck stepped aside and, according to Bloomberg, operations were suspended at the fund. Secondary buyers already have expressed interest, industry sources say.
Some LPs say the recent cases of inappropriate conduct could lead to a change in how the industry addresses sexual misbehavior.
“I think we crossed the tipping point where LPs will consider it part of their due diligence process,” Kim said. “Going forward maybe that is going to be a more standard diligence question.”
It also is possible the GP removal clause could broaden to include inappropriate behavior or sexual harassment.
Already calls from GPs, LPs and entrepreneurs have flooded legal advisors and industry experts with questions about maintaining business ties and taking investments from firms in the spotlight.
A new urgency seems to be taking hold.
Photo of sexual harassment complaint form courtesy of bdStudios/iStock/Getty Images