1. Double-check your LP agreements with public pension funds.
As elementary as this sounds, a lot of venture capitalists haven’t taken the time to review the terms of their contracts with public entities. The chief attorney for the State of Wisconsin Investment Board recently said that one-third of the funds it has invested in didn’t require it to sign a non-disclosure agreement. Are we to assume that, unlike the rest of their peers, these funds don’t care if their private returns are made public?
In addition to making an LP sign an NDA, venture firms should be very clear about how much information is going to be shared with LPs. For future fund agreements, GPs should seriously consider specifying that they will provide less private information to public LPs, since they are subject to Freedom of Information Act (FOIA) laws that can trump non-disclosure agreements, says Carl Metzger, a partner and litigation specialist with Boston law firm Testa, Hurwitz & Thibeault. He says he is already working with VC clients on the language for funds in the planning stage.
If you haven’t amended an agreement with your limited partners’ consent, do not start providing less information to public LPs without consulting an attorney. Taking unilateral action may open you up to breach of fiduciary duty lawsuits, warns Sean Caplice, a corporate and securities attorney at Gunderson Dettmer.
VCs who take money from public pension funds would do well to fully understand the disclosure requirements of their investors before accepting their money. Again, this sounds like a no-brainer. But, says Gary Bruebaker, chief investment officer for the Washington State Investment Board: “I am not sure private equity firms paid as much attention to [our laws] before as they will now.” WSIB has been making its private equity returns public for the last two decades. The funds that WSIB has invested in include vehicles run by top firms like Accel Partners, Battery Ventures, El Dorado Ventures, Menlo Ventures and Oak Investment Partners.
2. Sweat the small stuff.
Much of the risk venture capitalists face is a function of the growth of their industry. VC firms grew not only in the size of their funds, but in the number of offices they had spread around the United States and the world and in the number of people working for them. As with any business, growth brings with it a commensurate increase in the likelihood that something that would have been caught in a smaller environment somehow slips through the cracks. And that can result in a big fat lawsuit.
Metzger tells the cautionary tale of a venture capital firm that was sued because it didn’t notify one of its limited partners when it distributed the stock from the IPO of one of its portfolio companies. Simple mistake, right? Wrong.
Turns out the stock sat in an account, and, as was the case with many IPOs in the past few years, it quickly lost substantial value. By the time the LP realized the stock was in the account, the shares were worth millions of dollars less than at the time of disbursement. Rather than go to court, Metzger says, the venture firm settled the case for an undisclosed amount.
3. Assume your next fund will face a clawback.
If you plan for the worst, you won’t be surprised. At least two major firms have given money back to their LPs directly or through reduced management fees this year because of potential clawback liabilities. Spectrum Equity Investors, facing potential clawbacks on a 1997 fund and a 1999 fund, reduced its fees by more than $27.5 million this past summer. Likewise, TA Associates wrote checks totaling $38 million to its LPs in August to offset potential clawbacks on a 1993, 1996 and 1997 fund.
Yet another “major California-based venture firm with almost $2 billion under management” plans to reduce its fees because it’s “staring at a huge clawback, tens of millions of dollars,” says Anthony Romanello, head of investor services at Thomson Venture Economics (publisher of Venture Capital Journal).
“In response to changing market conditions, new funds that have been raised over the past 12-18 months are starting to include provisions such as escrow accounts and interim audits to address the concerns of LPs who now are much more focused on down-side protection and security,” Romanello says.
VCs are also adding contractual language that calls for an annual “true-up,” which is an auditing exercise performed by an independent, third party selected by the fund’s advisory board and paid for through the management fee. The auditor determines if the general partner owes anything back to the fund, and, if so, the GP must repay it in this interim period rather than wait until the end of the fund’s life.
VCs have a variety of other options, like letters of credit to guarantee that a clawback can be paid, says Steven Franklin, a partner with Gunderson Dettmer Stough Villeneuve Franklin & Hachigan.
As long as you have options, you may as well use them.
4. Resign from public boards.
Nowadays, sitting on a public board is like wearing a sign that says: “Sue me!” Defense costs for securities class action suits typically exceed $1 million, and the average settlement in such cases ranges between $7 million and $10 million, Metzger says. If the Securities and Exchange Commission gets involved in the suit, count on writing an even bigger check to your lawyers.
The biggest risk of being on the board of a publicly traded company is getting named in a class-action suit, but “it is becoming more common, not less, for individuals at companies to be named as defendants in all kinds of litigation,” Metzger says. “It can run the gamut from breach of fiduciary duty claims of various types to a significant risk of claims in the M&A context.”
Don’t assume you can just get director and officer (D&O) insurance to cover your back. “If we come across a firm with a habitual problem of sitting on public boards, there is a good chance we wouldn’t offer them [insurance] coverage,” says John Burkhart, worldwide product manager for Chubb & Sons’ venture capital insurance unit. Even if you’re able to get coverage, the average cost for D&O insurance is about 10 times as much for someone who sits on a public board than someone who sits on the board of a private company, Burkhart says.
Anecdotal evidence suggests that more VCs are giving up public board seats following the Enron scandal and the stiffer penalties for rogue directors that came with the passage of the Sarbanes-Oxley Act in July. But it isn’t hard to find venture capitalists who refuse to relinquish their prestigious public seats and maintain that the benefits of being on a public board, such as the ability to network for portfolio companies, are worth the increased scrutiny and risk involved.
5. Prepare for both sides of a washout.
With valuations plummeting from the overzealous Internet days, washouts have become far too common. And while you don’t want to be the one getting washed out, ending up on top can make you a target for lawsuits-and not just from angry entrepreneurs. Don’t rule out the possibility of getting sued by a VC that once co-invested with you. Benchmark Capital broke a long-standing record of never having sued anyone this past summer when it filed suit against Canadian International Bank of Commerce (CIBC) and portfolio company Juniper Financial. The suit, which claims that CIBC and Juniper wiped out $115 million worth of investments (including $25 million by Benchmark), is ongoing. (None of the parties involved could be reached for comment at press time.)
While the Benchmark case may shed some light on the rights of minority shareholders in down rounds, VCs are often the controlling stockholders in their portfolio companies. It is in this role that they must take particular care of when considering a down-round financing.
Christopher Aidun, a partner with Weil, Gotshal and Manges, outlines a number of steps VCs should take to reduce their risk of getting sued when they come out on top in a down round. Among them: Create a committee of independent directors to evaluate the new financing and negotiate its terms with the controlling stockholders; and offer the deal to all stockholders on a pro rata basis with their current ownership of the company so they can’t say you kept the deal all to yourself.
6. Be sure: Insure.
When the economy sours, people always start looking for someone to blame-and it’s usually the guy with the deep pockets. A VC may not have done anything wrong, but a jaded entrepreneur can still file a nuisance suit to try to get a settlement. That’s why an increasing number of firms are taking out insurance policies to protect them against lawsuits.
The National Venture Capital Association has been offering insurance to its members for some time, but it’s never been more popular. The manager of one insurance firm with offices nationwide says his firm wrote twice as many policies for VCs in the first three quarters of this year than it did in the previous nine months. The coverage is expensive-as much as $200,000 a year, according to one estimate-and prices are rising as demand increases. Then again, can you put a price tag on peace of mind?
7. Keep your LPs fully informed.
No one likes surprises-bad ones, anyway. As they have watched their investments vanish, frustrated LPs are more willing than ever to use their lawyers to get what they want. The claims by LPs generally focus on mismanagement of fund assets and ignoring the guidelines of limited partnership agreements and private placement agreements. Most complaints never see the light of day and are settled quietly between GP and LP, but a few cases have been made public, including suits filed against Forstmann Little & Co., Idealab Inc. and MeVC.
“It used to be that the risk of claims by LPs was negligible,” Metzger says. “But we have seen more of these types of claims in the last couple of years, and I anticipate we will see more.”
As in the Forstmann Little case, the claims being made by LPs typically focus on VCs that went on allegedly rogue investment binges outside of the agreed upon terms of the partnership agreement.
“The firms that are in trouble with their LPs are the people that went out and effectively didn’t pay attention to or chose not to pay attention to their companies and their agreements,” says Chad Waite, a partner with OVP Venture Partners of Kirkland, Wash. “If we did that, before they sued us, our LPs would get on the phone and yell at us. But we’d never do it, because we would talk to them first.”
In difficult times, both VCs and their limited partners must have a clear understanding of investment objectives and the risks involved. Those objectives can be clearly stated in partnership agreements, but they should be revisited regularly as the life of a fund plays out, investments are made and economic cycles rise and fall. It is very hard for a limited partner to prove that a venture firm went beyond the investment objectives of a fund. To win a suit like that, an LP must demonstrate that a VC intentionally misled it, as was the situation in the oft-cited case by Lincoln Life Insurance Co. against A. David Silver. The suit, filed in 1995, alleged that Silver had invested heavily in a few computer companies in which he had a personal stake. The jury found in favor of Lincoln Life and awarded it more than $22 million.
8. You’re a big business. Act like one.
Where informal rules understood by a small group of people at a VC firm worked in the past, the growth of the venture capital world makes that an impractical and dangerous way to operate a firm. Just like public corporations, venture firms should establish formal policies and procedures to reduce the risk of litigation.
For example, VC firms should establish a well-defined insider-trading policy that prohibits trading the stock of portfolio companies or even non-portfolio companies if it is based on non-public information gathered during the course of doing business with its roster of companies. Blackout periods should be put in place and enforced, as well as a policy of not making recommendations to LPs about what to do with their stock. Also, set up procedures at portfolio companies for dealing with the investing public, including a written revenue recognition policy. The key to all of this is consistency, being able to show that a venture firm has a set of rules and that its partners adhere to them.
9. Be a straight shooter.
Keeping open lines of communication with LPs is clearly important, but if the information being passed over those lines isn’t dead-on accurate, what’s the point? Waite of OVP says he has responded to the downturn not by revamping his partnership agreements but by just being very responsive to the questions and concerns of his limited partners. “Our position has always been don’t get too aggressive in the good times with terms and conditions, and never forget who you work for,” he says. “If you don’t push the envelope in the good times, you are not going to experience a lot of the heartburn in a bad time.”
Waite has simple advice for those now suffering the legal wrath of their portfolio companies and limited partners: “Give them honest, straightforward valuations. If a company is struggling, write it down. And if it’s done, write it off. But don’t try and keep fooling people. It doesn’t work.”
10. Don’t always listen to the experts.
There has to be a balance between what the lawyers, the LPs, the government, your portfolio companies and your partners want as a hedge against failure, and what it takes to do the job of a venture capitalist properly.
Metzger, the attorney, cautions VCs that they run the risk of exposing themselves to a suit from a miffed company founder or other investors if they get too involved in the day-to-day operation of a company and it fails. A lawsuit in such a situation would rely on the “control person” theory of liability. That is, the VC sitting on a board used his/her influence and inside knowledge to control the business of the portfolio company. With this in mind, Metzger advises venture capitalists to have no direct, official roll in the day-to-day management of their portfolio companies.
For the same reason, VCs acting as directors of their portfolio companies should be cautious about leaving a paper trail of notes, memos or email concerning decisions about sales or distribution of portfolio company stock, he says.
Metzger’s concerns make sense, coming from a lawyer. But do they make sense for a venture capitalist? If a company is struggling, isn’t it the VC’s job to jump in as interim CEO while a search is being conducted? How will the company make it if the VC/acting CEO is more worried about not leaving a paper trail than making sure the company ships a key product, lands a critical customer or has the right VP of sales on board?
At some point, the only expert you need to listen to is your gut. If you’ve got a promising portfolio company that’s going through a bit of a rough patch, you are probably right to do what VCs have done time and time again: step in and save the day. But, on the other hand, if you’ve got a company that’s teetering on the edge and you have a strong sense that its founders are going to try to blame you for the demise, you’d probably be wise to accept the fact that the world has changed and that any effort on your part, no matter how well meaning, could put you and your firm at risk.
Email Lawrence Aragon at