VCs Fear Hummer Suit May Set Precedent –

If Hummer Winblad can get sued, maybe we’re next.

That’s what most venture capital firms are saying in light of the recent suit by two record companies against Hummer Winblad Venture Partners (HWVP) for its connection to controversial music swapping service Napster Inc. VCs and the National Venture Capital Association (NVCA) say they’re worried that the HWVP suit will set a precedent that will send others poking around the deep pockets of venture capital firms.

But attorneys who aren’t involved with the case say this is a one-shot deal. HWVP incorrectly invested in Napster when it was already in hot water and made things worse by installing one of its partners as Napster’s interim CEO, the attorneys say.

Universal Music Group (part of Vivendi Universal) and a unit of EMI Group PLC filed suit on April 21 against San Francisco-based HWVP and two of its general partners: Hank Barry, who was once Napster’s interim CEO, and John Hummer, the firm’s co-founder.

The suit, filed in the United States District Court in Los Angeles, alleges that HWVP, Barry and Hummer personally contributed to copyright infringement by giving Napster financial support. The suit claims that Napster enabled billions of songs to be illegally copied and it seeks $150,000 per copyright violation.

“Businesses, as well as those individuals or entities who control them, premised on massive copyright infringement of works created by artists, should face the legal consequences for their actions,” Universal Music and EMI said in a joint statement.

HWVP did not return calls for comment.

The NVCA, which had heard rumors of a possible suit for months, sent a letter to three U.S. senators on the Banking and Small Business Committee. The letter states that the NCVA is concerned that naming investors in such lawsuits might cause venture capitalist to shy away from high-risk technologies.

“Venture capitalists are working on behalf of their investors,” NVCA President Mark Heesen said in an interview with Venture Capital Journal. “You want to see VCs be active investors. You don’t want to see them put money into a deal and then walk away. There was lots of talk a couple of months ago that [HWVP] would be sued. I think the record companies are looking for deep pockets.”

Heesen went on to say: “A VC has to look at a deal and decide if the technology is cutting edge enough to transform a specific industry and if it’s going to be a good company that can pay some dividends to LPs. If you don’t see that, you don’t invest. But if you do see that, it makes sense to invest.”

Chill Factor

The NVCA isn’t being alarmist, according to some VCs. Spencer Tall, a general partner with APV Technology Partners, says that if the lawsuit can reach as far as the investors, then his firm may rethink its investment strategy. “Venture capitalists have to be able to take risks,” he says. “If a lawsuit’s arms can reach us, then we would certainly give any new types of technology more careful consideration before putting money into them. It would seem that the only way to protect yourself is not to make certain investments, which would stunt innovation. Some great technology might not ever see the light of day if this can happen.”

Even after doing the most exhaustive due diligence, as HWVP claims to have done, investors can still get it wrong. Some feel it is a judgment call and in HWVP’s case Napster’s business could have been successful. “You look at the market, you look at the financial resources of the company, you look at the management team, and you look at the company’s potential. Even if the deal is risky, if everything checks out there’s a judgment call to be made,” says Jonathan Silver, founder of Core Capital Partners of Washington D.C. “Sometimes venture capitalists get it wrong. Investing in a company that already had lawsuits pending against it should have raised a red flag, but in the dot-com era deals were being done at a fast pace and many VCs forgot to cross their T’s and dot their I’s.”

“We should be protected like shareholders in public companies are protected,” says Darryl Wash, a managing partner with Ascend Ventures of New York City. “So if someone smokes and wants to sue R. J. Reynolds fine, but should they be able to sue shareholders? If this type of lawsuit is allowed to happen, it could seriously curtail the investment dollars that go into young companies that do carry risk.”

Poor Judgment?

Some lawyers say that HWVP’s decision to install Barry as the troubled company’s CEO opened the venture firm up to the lawsuit. Barry was CEO for more than a year beginning when the firm made its $13 million investment into the company in May 2000. Also, HWVP made the investment after Napster was already being sued by the recording industry for copyright infringement.

“The product was dubious in its own right and then you put your guy in charge of it?” says Peter Lavery, an attorney with Traub Bonacquist & Fox LLP. “During due diligence, Hummer should have been seeing major red flags. Napster had been wearing a kick me’ sign on its back for years. What we are talking about is a high-risk investment that had potential for a high return. If you step into the ring you could get punched, and they did.”

Copyright attorney Jennifer Silverman from Reed Smith says from the very beginning Napster was breaking the law and should have been shut down, not given venture capital. “The copyright violation was clear from the beginning,” she says. “I can see why an investor would find an opportunity to invest in this type of technology so exciting, but it has always been so clearly illegal.”

At the time that HWVP invested in Napster, investors and analysts alike questioned why a respected VC firm would take an ownership stake in a company that was just one judicial ruling away from being shut down. In October 2000, Dan Beldy, a partner with the firm, told VCJ’s sister publication Private Equity Week that that HWVP did an exhaustive five-month due diligence with Napster and the firm felt confident that the law was on its side.

“No investor wants to take on market risk, let alone legal risk,” Beldy said. “But we are very confident in this company, and we wouldn’t have made the investment if we thought there was even a chance of something happening from the liability perspective. Of course, you can’t prevent someone from suing you, but we don’t see it happening.”

Infamous last words?