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Litigation pitfalls for venture firms

Recent developments in litigation have been challenging the traditional structure and operations of venture capital and private equity funds.

"In the past, suing a VC was not as prevalent as it is today because of a fear of industry ostracism," said Mike Rhodes, a partner with Cooley Godward LLP and co-chair of the law firm's Venture Capital Litigation group. "This is no longer the case and funds are finding that they need to adjust their operations procedures to reduce the risk of litigation."

Litigious disputes are often seen at the limited partner level, involving grievances toward the general partnership or management company. The number of disputes has increased since the bubble burst -- and so did the dreams of many LPs -- in 2000.

The most common dispute centers around the implied relationship between a partner and the management company, and contractual obligations.

For example, nearly every investing executive within a fund uses the title "partner." However, the definition of partner within the venture capital industry is not always consistent with other businesses, such as law firms and accounting firms, and can become problematic if the management company wants to exclude a participating LP on a new fund or when cashing out a prior investment.

It can be argued that a person with the title partner is inherently guaranteed participation in later funds, which makes it difficult to uninvite LPs to participate in new funds and investments.

To reduce the risk of partner litigation due to misrepresented contractual rights or assumed fund participation, Rhodes suggests adopting the investment bank model of titles, utilizing "vice president" and getting rid of general partner and limited partner.

He also suggests having tight, integrated contracts limiting rights and preventing claims beyond specified management fees and carried interest, as well as clearly defining the compensation for partners, associates and venture partners.

"The main lesson is to synchronize behavior with documentation and agreements," Rhodes said.

The second trend in litigation is "failure to fund." This risk is most commonly found at any of three stages of a company's life: seed, mezzanine and closing the doors. At the seed money stage, a VC meets with a company and tells the entrepreneur that if they find a lead investor, or make a few changes in the plan to increase fundability, the fund will invest.

The second scenario takes place in a mezzanine round. After participating in two rounds in Company A, the fund decides not to continue support in the next round.

The third scenario is when a portfolio company is at the end of its life. If the fund refuses to bail the company out, the decision will be met with scrutiny by insiders and creditors looking for any basis to claim that other financing alternatives were not pursued on assurance that another round by the fund would be there in the end.

All three of these scenarios fall into the category of "failure to fund." In the seed round, or any time an entrepreneur meets with a fund in hopes of securing capital, the VC runs the risk of sending a message to the entrepreneur that can be construed as a promise to fund. The mezzanine round and final death scenarios are similar in that by participating in prior rounds, the fund has created a perception of fiduciary duty or promise to continue financial support.

Most of these disputes can be lessoned by the application of clear risk management procedures.

Gordon Atkinson, a partner in Cooley's San Francisco office and co-chair of the law firm's Venture Capital Litigation group, emphasizes the use of a document retention policy as a preemptive measure to shortening the life of litigation.

In the case of seed and initial investment rounds, he suggests a standard procedure of responding to every business plan that is submitted to a firm -- unsolicited and referred -- and that the firm has no intention of funding, with a standard form letter that clearly states disinterest, original information is enclosed and all hard and soft copy documentation has been destroyed. This helps establish a case if a company comes back with any reason of "failure to fund."

Obviously, the next step is to actually destroy and delete the plans.

An example of the value of documenting the closing of a file is another common litigation scenario where a business plan comes over the transom and includes confidential intellectual property information. The fund never looks at the plan and it sits on an e-mail server or hard copy in a file somewhere. Coincidentally, the fund invests in a similar company later down the road and the first company claims an IP conflict.

"The complaint by that individual will have much shorter legs if you respond and say 'we've read your plan and we're not interested,'" Atkinson said.

Similar documentation can be applied to the later stages of investment of an existing portfolio company. Rather than a procedure of closing a file, the risk management comes in the form of being careful not to create claims of obligation to fund based upon oral statements made following the closing of the first investment through all of the board of directors' meetings.

The same applies to e-mail communication. In the age of daily business e-mail correspondence, e-mail messages can be taken out of context and used to prove fiduciary duties or gross negligence on behalf of the VCs and board members. Atkinson advises his clients to follow the New York Times rule of never writing an e-mail that you don't want to see published.

Rhodes goes a step further and challenges the VCs to question its marketing language, particularly on a Web site.

"A lot of VC firms sell the relationship and ability to help companies with overall strategy and to find good personnel," Rhodes said. "However, if it doesn't work out, shareholders can and will use the marketing language in litigation to establish a relationship between the fund and the companies in the suits and pursue financial reparation."

Another questionable marketing practice is the inclusion of a mechanism for companies to submit business plans via the fund's Web site.

The invitation to submit can create the assumption that the information is confidential, secure and implies a confidentiality agreement. Going back to the IP scenario, even if the VC never reads the plan, if litigation begins and the plan is found within the computer or hard copy files of the firm, the entrepreneur could have a case.

Rhodes questions the concept of inviting companies to submit plans via the Web site as it merely creates a litigation risk.

"I talked to a number of funds and they hardly ever fund these plans," he said. "So why are they doing it?"

Through the increasing existence of these issues, venture funds are being required to act more like a traditional business and protect itself from within. The two rules Atkinson emphasizes are to never discuss legal issues except with a lawyer and when in doubt, direct e-mail or copy your attorney.

"Have some process that is demonstrative later. That will protect you against litigation and explain your thinking," Rhodes concluded.

Milne Barger is a marketing specialist at Cooley Godward LLP.

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