Rare Suit Against VCs Lands in Court –

Once largely immune from lawsuits because of its close-knit nature, the venture industry is starting to show signs of increased litigation as it grows ever larger and more institutionalized. Case in point: a private placement agent took Worldview Technology Partners, Jerusalem Venture Partners (JVP) and several others to court for about $55 million.

The agent, Spencer Cleveland of San Francisco, filed the breach of contract suit back in November 2000. It went to a jury trial in California’s Alameda County Superior Court on Jan. 5 and was still being heard when VCJ went to press on Feb. 17.

Among those called to testify were Worldview General Partners James Wei and Ajit Shah.

A suit like Cleveland’s is unusual. What is even more remarkable is that it made it to trial, according to attorneys who represent venture firms but who aren’t involved with this particular case.

“I’ve never seen anything like that,” says Darryl Rains, co-chairman of the Securities Litigation Group at Morrison & Foerster in Palo Alto, Calif. Rains and other MoFo attorneys are frequent defenders of public companies involved in shareholder lawsuits and of venture capital firms that are sued by investors.

Rains says the two most common suits against VCs involve “misrepresentation claims” and down rounds. In the former, either a company’s management or prior investors are alleged to have misled later-round investors about problems that a startup has. In the latter, investors from early rounds sue VCs who have devalued earlier investors.

Cleveland’s complaint is principally for breach of contract. It claims that he was hired in 1999 to raise money for the optics company InLight Communications Inc. (formerly known as MEMS Inc.), which filed for bankruptcy in 2001.

Although Cleveland brought InLight the makings of a potential investment of $65 million, InLight executives broke their contract and non-disclosure agreements with Cleveland and pursued alternative venture funding from JVP, Worldview and others, his suit alleges.

Specifically, the suit claims that InLight hired Cleveland to raise a minimum of $2 million in funding, of which he was to receive a fee of 7% of the amount raised. Cleveland identified E-Tek Dynamics as a company “interested in InLight as part of a group investing $15 million in a first round and investing $50 million in a second round,” the suit alleges. Had the deal gone through, Cleveland stood to make $4.55 million, or 7%, of the $65 million total.

The suit also claims that rather than pursue the deal with E-Tek, InLight executives broke their non-disclosure agreement with Cleveland and shared information (about E-Tek’s interest and a business plan drawn up by Cleveland) with Teddy Shalon, a consultant and investor in startups. Shalon then shared the “confidential and proprietary information” with other prospective investors, who ultimately invested $2.48 million in InLight’s first round and $11.5 million in its second, the suit claims.

(The Thomson Venture Economics VentureXpert database shows that JVP and an undisclosed venture investor made a first-round investment in InLight in June 2000 and that JVP and Worldview did the second round in September 2000 at a post-money valuation of $26 million.)

Cleveland’s suit originally asked for total damages (including punitive damages and damages for emotional distress) of about $128 million. It also listed six causes of action. Later, the court reduced the total amount that Cleveland could seek to $54.55 million, and it reduced his total number of claims from six to three, according to Kara Andersen, who represents all the defendants in the case. Cleveland’s claims for emotional distress and punitive damages were also tossed out, Anderson says.

Richard Harrington, a San Francisco attorney who represents Cleveland, did not return phone calls seeking comment.

Cleveland says that he turned down a $1 million settlement offer and that the defendants rejected his request for a $15 million settlement. Andersen confirmed that there was a settlement conference, but says that her clients didn’t make a $1 million offer to settle.

“The defendants completely deny the allegations [in Cleveland’s suit] and feel they are outrageous,” says Andersen, a partner with San Francisco law firm Keker & Van Nest LLP. She adds that she is “pleased with the way the evidence has come in so far.”

Asked what the case is about, JVP Principal Adam Fisher, who was involved in the original investment in InLight, says: “We’ve been asking ourselves that for a long time.” He says that none of the investors were aware of Cleveland’s contract with InLight before they invested, despite careful due diligence.

He notes that JVP has invested in about 50 portfolio companies and has looked at hundreds of deals. “No matter how much due diligence a VC does, these kinds of things [lawsuits] happen,” Fisher says. “If these sort of things were to become common, no venture capitalist would invest.”

It is incumbent on Harrington, Cleveland’s attorney, to prove that JVP, Worldview and the other defendants in fact knew of Cleveland’s contract with InLight and chose to cut him out of a deal so that InLight would not have to pay his fee. During a deposition, Harrington pressed Worldview’s Wei about his alleged knowledge of Cleveland.

A court transcript shows a clearly frustrated Wei.

“I absolutely feel I’m being harassed,” Wei said after Harrington asked him about an email allegedly sent by Shalon to InLight’s CEO and CFO. “You’re asking me about emails that that – that I have no access to. You’re asking me to interpret emails. I’ve already said three times already, I have never heard of Spencer Cleveland until this whole thing was brought to my attention.”

Grant Collingsworth, a partner with Morris, Manning & Martin in Atlanta, said via email: “The most likely way [for the plaintiff] to succeed is to show a conflict of interest if the VC sat on the board, and it’s not uncommon for VCs to be conflicted on decisions of financing, etc. … If the VCs got sloppy and didn’t take care to insulate themselves from this, there’s a likelihood of liability.”

Collingsworth, who is not involved in the case, adds that the suit reminds him of “the lender liability suits we saw in the late 80s. After companies went down, they started suing the banks on lender liability.”

Additional reporting by Jerry Borrell and Alastair Goldfisher.

Email: lawrence.aragon@thomson.com