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When Venture Investors and Companies Clash

Daily Journal

In Silicon Valley and other business hubs with thriving startup scenes, the relationship between venture capital funds and the companies in which they invest is often amicable. After all, an emerging company's success - measured by growth followed by an eventual acquisition or initial public offering - requires no small measure of cooperation between a startup and its venture backers. But every once in a while that bond unravels, and the parties find themselves in litigation. And those disputes can become especially sticky because of the widespread practice among venture capital firms of installing partners on their portfolio companies' boards.

"Every time there's a venture director on a board, they have the issue of whether or not their loyalties are divided," said Keker & Van Nest LLP partner Stuart L. Gasner, a litigator who has handled spats between companies and their venture investors. In the face of litigation, determining what "hat" an investor must wear can be a murky legal question, attorneys say.

"In certain circumstances, the controlling shareholder has fiduciary obligations. What those obligations and circumstances are very fact-specific and complicated, and the legal rules can be difficult to untangle," said Fenwick & West LLP partner Christopher J. Steskal about the conflicting fiduciary duties at play.

As a result, many lawyers say they're pushing for more clearly defined contracts between emerging companies and their investors that can cut through the ambiguity of what rights and duties an investor owes to its portfolio companies. "It's about working with counsel to understand your obligations so that when these issues arise, you're prepared to handle them," said Joshua G. Hamilton, a Paul Hastings LLP partner in Los Angeles. He noted that fiduciary duties will vary based on the transaction.

"At the outset, the most important thing to do is inform the directors of their fiduciary obligations to both [the company and the fund]," Hamilton said. A March 2013 decision from the Delaware Court of Chancery helped bring the issue to the fore.

In that case, the founders of software developer Bloodhound Technologies sued their venture investors after realizing that their equity holdings had been gradually whittled down to less than 1 percent over the course of a decade. It was a discovery they made only when the company was sold for $82.5 million in April 2011 to Verisk Analytics Inc. Carsanaro et al. v. Bloodhound Technologies, Inc. et al., C.A. No. 7301-VCL (Del. Ch., Mar. 15, 2013).

While their investors took in millions from the sale of the company, Bloodhound's founders made out with less than $36,000. They claimed the venture backers breached their fiduciary duties by acting solely in their own interests. The defendants argued their decisions were legally sound and should be assessed under the business judgment rule, which gives corporate actors wide latitude in operating a company. Vice Chancellor J. Travis Laster disagreed, and denied the investors' motion to dismiss. The case later settled out of court.

Venture capital investors typically take on the role of board directors when a portfolio company needs to take a vote on a vital decision - to take on more funding or wind the company down, to put itself up for sale or begin the process of filing for an initial public offering. Taken together, Steskal said, that means that transactions often act as the springboard for litigation if friction arises.

Attorneys say best practices dictate a venture director immediately recuse himself or herself from a decision - and possibly from the board altogether - if there's an irreconcilable disagreement over the company's direction.

"Even though they have a fiduciary loyalty to the company itself, the fund's interests may come into conflict with the company's interests and ... it's on the investor-director to manage that issue," said DLA Piper corporate and securities partner Curtis L. Mo.

"We counsel people to get separate representation right away," said Sidley Austin LLP partner Hank Barry, who co-chairs the firm's emerging companies and venture capital practice group. "Sometimes that can be hard to do because you have personal relationships involved," he added.

But while a swift recusal is what most attorneys will recommend at the first sign of a conflict, in other situations, legal experts often disagree on what a venture fund's obligations are.

One case that Gasner handled in recent years involved a dispute over whether a venture fund was abusing its so-called "blocking rights," which allow an existing venture-director to veto new investments in order to prevent dilution.

"The question was whether [the blocking rights were] being used just to kill the company, to liquidate it, or whether it was being used for the purpose that it was intended for," Gasner said.

The case settled out of court, Gasner said, but not before a former Delaware Supreme Court Justice and a law professor who weighed in on the matter disagreed over whether the fund's fiduciary duties to the company prevented it from exercising its blocking rights.

Ultimately, attorneys say conflicts over fiduciary duties can be minimized, if not avoided, by more explicitly defining the rights and duties of venture backers early on. That's because Delaware Chancery Court jurisprudence of late has appeared to rely on the contracts underlying a dispute, Gasner said, not analyses of common law fiduciary duties.

"The more specific you are in the contract about what rights you have and the scope of how you're going to handle different situations, [the better]," Gasner said. "If you're in Delaware and it's all laid out in advance, then when you get into rough waters, the more specific the contract is, the less dispute there is."