From: cpart2@corporate-partnering.com
To: tom@eprairie.com
Cc: RONALDMAY@aol.com; Ron May; brianm@siliconalleyreporter.com; douglas.mintz@siliconalleyreporter.com
Subject: "When Dot-Coms Strike Out, Will Startups Strike Back Against VCs?"
Date: Monday, January 01, 2001 7:14 PM

Tom,

In regards to your article about "When Dot-Coms Strike Out, Will Startups Strike Back Against VCs?" Law suits are not out of the question.

I am a lawyer and have served the boards of Venture Capital funded companies.

What is happening to these VC funded dot.com companies is a natural outcome of how the VC industry functions. To the extent that many of the founders and early investors of these companies were not warned of the risks they were taking (and the real rules of the VC process) when they accepted VC funding, they probably have the moral and legal right to sue some of their advisors, VC board members, and even VC firms.

It's hard for me not to believe that many of them were let into the VC process without being fully advised about how it really works and really doesn't work ... and in many instances actively misled by those who should have known better and who in fact had substantial economic interests in keeping them dumb and trusting.

While each situation is different, It's likely that most of these companies had a number of advisors (including VC board members) who had an obligation to warn them of the rules of the game, the risks they were taking, and potential conflicts of interests between them on one side, and their advisors and VCs on the other side.

HOW THE GAME WORKS - A DIRTY LITTLE SECRET

Here is how the game works. How it really works is a dirty little secret... but its pretty obvious once it is explained. It's so obvious that once the secret is out in the open its pretty hard to deny it. Unfortunately everyone involved has a vested interest in denying it. Here it is. Once a company gets VC funding, the VC gets a de facto exclusive on all subsequent rounds of financing. No other VC will step in without the approval and consent of the prior VC. This is a standard provision in the investment agreements... and it would work this way even without such contractual provisions. VCs are just not going to get into bed with the same portfolio company without the acquiescence of the prior VCs (any exceptions to this are just that... exceptions).

THE FIRST ROUND VALUATION IS THE REAL RED HERRING

If you think about it, the valuation on the first round isn't all that important. Why? Because most of the funding is expended in subsequent rounds. Think about it. The amount of money put into rounds C, D, E, and F is invariably going to be greater than what goes into rounds A and B.

The focus on first round valuation is just used to distract the founders from the real issues which are the terms of the investment (the "fish hooks" that can't be removed). The first round of investing is just the cost of acquiring an exclusive on subsequent rounds and the entry price for doing real due diligence on the investability of the company and its management.

Most VC's avoid like all heck giving a company enough money in its first round for a portfolio company to have enough capital to make it through to profitability. They all prefer to keep their portfolio companies on a short leash. No matter how much the company asks for, the standard VC response is to give a portion of it up front... and then make subsequent rounds conditional on how happy they are then. If the VCs get duped and the company is able to get on its feet without subsequent rounds... well they have probably won any way.

But they actually include provisions in their investment agreements that make this last scenario highly unlikely.

This means that VCs prefer capital structures in which a company has a burn rate that will force the company back to the VC for more money long before it is able to become economically self sustaining. This is often made easier by the fact that many founders will self delude themselves into thinking that they need only that first round.

The scenario this produces is a company with a high burn rate operating at a high altitude while it is sitting down to negotiate its next round of funding... just as it is about to run out of gas. The founders have only one deal. They have everything at risk. The VC has a whole portfolio of deals... this is just one of many. And the VC's hand grows stronger and the plane starts to fall out of the sky.

Who do you think wins this negotiation?

I won't even address the issue of the poor victims who, after they find themselves in this predicament, try to extricate themselves by looking for new money from other members of the VC community.

Whether the VC owns 51% or 20% of the company... it doesn't matter, it's all the same. Even if the founders retain 80% of the voting stock, as soon as the transaction closes, they have ceded control over to the VC. It's just that frequently it doesn't become all that obvious to them until things start going bad... and it's seldom explained to the them... they have to figure it out as it happens.

IT'S THE LAST ROUND THAT COUNTS

VC's know the game and they know the rules. A high burn rate and piecemeal rounds of funding put them in charge. They can then use that power to dilute out the founders, and any other investors, who don't have the wherewithal to continue to throw money into the pot with each subsequent round of funding. Whoever is still in the game on the last round is the real winner.

By the way, a number of years ago Stanley Pratt did a study on the mortality rate of CEOs in VC funded companies. He found that they burned through an average of 3.3 CEOs each. The first casualty is the founding CEO.

In many instances it would be to the benefit of the founders to get their first round of funding and then conserve on their burn rate to make sure that the first round takes them to a self sustaining level of operations. I am not just talking about control here. I am talking about the total amount of personal wealth they are able to harvest from their own company.

On the other hand, the VC's economic interest is optimized by have a number of high risk / high reward / high burn portfolio companies in their portfolio. They just can deliver the high rate of return that their investors demand any other way. The few winners more than make up for the many losers.

THE GAME ISN"T CROOKED BUT ITS NOT FAIR EITHER

It's as if the VCs are running a casino whose games are stacked against the entrepreneurs who enter it. The house always wins. There isn't much wrong with that if the marks understand the rules and the odds. Where it starts to get actionable is when they are duped into thinking that the games works one way, but in fact work another.

The games aren't crooked, but they aren't fair. The games favor the house. CEO's who try to throttle back their burn rate, and run safe, are treated like wimpy card counting cheats... that aren't made out of the right stuff. They are disparaged, held in contempt, and quickly run out the door.

Most VCs have even taken to including provisions in their investment agreements that require founders to spend money only in conformance with a budget that must be agreed to by the board (i.e. the VC) and must be followed by the founders. The budget can be changed only by approval of the board (i.e. the VC). This makes sure that the founders can't throttle back expenditures without getting permission.

HOW THE INSIDERS WORK TOGETHER AT THE EXPENSE OF THE OUTSIDERS

Founders are actually encouraged to believe that once they get a VC on board, there is a congruence of interest between them and the VC... that the VC is now on their side. Many seem to get hoodwinked and buy into this. Unless they have a checkbook that permits them to participate in subsequent rounds of funding, it's simply not true.

I actually sat in on a board meeting where the VCs asked the founder to leave and then started discussing how they were going to squeeze him out. The plan was to force the founder to spend all his cash and then impose a forced round of heavily dilutive financing on him. The plan had nothing to do with what was good for the company... it had to do with the VCs hijacking control of the company from the majority shareholder founder and then benefiting at the expense of all the other shareholders who didn't have the means to participate in that next round of investment.

The VCs proselytize a great deal of propaganda about founders who don't play the game the way the VCs want them to. That they are the lowest of the low. That they are small minded losers. That they are control freaks. That they are not deserving of investment.

The VC's proselytizing disciples are many of the same advisors that company founders rely on to guide them in their dealings with VCs.

And get this, these advisors actually get the potential clients to pay money to attend seminars where they are fed this propaganda and are pitched services. The services and the VC money are pitched as a joint proposition. How is it that someone who is pitching their services as a route to obtain VC money can advise a client on both the advantages and the disadvantages of this type of money?

This system works well for the VCs, works well for the advisors.. but maybe not so well for the founders.

REALITY

Of course no VC is going to needlessly harm a portfolio company.

What happened with all the dot coms was that many were put at risk and really didn't understand what a precarious position they were being put into in order to benefit (a) the VC's ability to step and exercise control when necessary, and (b) maintain the company's course on a risk/reward ratio that benefits the VC's interests at the expense of the founders.

Think about (a) the intense pressure that VCs face to deliver results to their investors, (b) the VC's fiduciary obligation to do the best they can for their investors, and (c) the reality that the VC money enables the purchase of services from the very firms that advise the portfolio companies on accepting the VC money.

If you do, it's hard to believe that the system could operate in any way other than the way it does.

When the bottom dropped out of the financial markets the VC's backed away from their portfolio companies. They really had no choice. The money with which they are entrusted is not patient money. If they can't flip the stock to greater fools, they lose. Their own investors will park their money with someone else who is more ruthless.

Basically if they are too kind, their money will be taken away from them and they will be kicked out of the game.

The VCs isolated themselves from the risk of a market reversal as best they could. They parceled out the money in as small of chunks as they could. All the while they encouraged unsustainable burn rates and a dependency on future rounds of financings to support the burn rates. In fact, through investment agreement provisions controlling budget matters, they in effect locked these burn rates right into the relationship.

If someone is let into this casino and isn't properly explained the rules of the game (rules that give the house an unfair advantage), it doesn't seem like whining to hold accountable the people who brought them into the game.

Now if they were actively misled as to how it works, they would have an even stronger case.

It's hard to believe that in all these cases of failed dot.coms (and founders squeezed out of their own companies) that the founders were fully advised before hand about what they were getting into.

It's hard to believe that many of them weren't egged on by their own advisors as well as the by VC's who like to claim that their advice is even more important than their money.

THE CHICKENS MAY COME HOME TO ROOST

VCs do little to restrain their own lawyers when imposing one sided agreement on their portfolio companies. The VC attorneys are unwilling to make any changes to any provisions except for those that don't count. They grant just enough leeway to permit the portfolio company's attorneys to pretend they are actually engaged in negotiation.

The result of this are some of the most one sided agreements that exist in the business world.

My personal belief is that in many instances the portfolio companies are in technical violation of some provision of their investment agreements the day they sign them, or soon after.

There is a legal term for such contracts. They are called "contracts of adhesion" and are not favored at law.

It wouldn't be all that difficult to prove that the key provisions are non-negotiable. A properly drafted complaint would support inspection and copying of all of a VC's prior investment agreements to confirm this. I have no doubt what such an inspection would find.

The VC's could also be subject to legal attack for their advice and actions that occur after the first round of investment. There are lots of hands washing other hands in this industry. When a portfolio company comes out the loser for it, maybe some of these hands need to chip in to pick up the cost.

The one problem with such lawsuits is similar to the problem that faced the first medical patients to bring malpractice law suits against their physicians.

Back then they called it a "conspiracy of silence". All the medical personnel involved looked the other way and denied the facts and the culpability. From your article on this subject, it sounds like the same "it can't happen to us" denial and conspiracy of silence is occurring here.

The physicians were mistaken to think it couldn't happen to them. The firms that advised these VC funded companies and the VC's who supplied them funding may be making the same mistake thinking that it can't happen to them.

I do expect that it will take a few wins to prime the pump on this litigation, and that the early defendants may be professionals who supplied services to the portfolio companies while really owing their economic allegiance to the VCs. But there are more than enough legal theories under which VCs can be held accountable.

I went on far longer than I intended to when I sat down to write this. In any event, let me hear your comments on the above.

You would do a great benefit to your readers by educating them further on this subject.

Curtis Sahakian
cpart@interaccess.com
847/676-2774

PS: I'm going to copy Ron May and siliconalleyreporter.com on this and see if they have anything to add to the subject.

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