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Bringing Down the Fund: How One VC Almost Made the Multi-Million Dollar Mistake of a Lifetime
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Paul Koenig is co-founder and managing director of Shareholder Representative Services, which serves as a shareholder representative following the acquisition of a VC portfolio company. It’s not often that we hear about an event that could have crippled a venture capital fund, wiping out years of success and severely impacting the fund’s operations, returns and ability to raise future capital. We recently did, however, and we wanted to report on it so that other investors would gain a deeper understanding of the risks and responsibilities that are thrust upon the individual or firm that takes on the role of a shareholder representative following the closing of an M&A transaction. The following is based on a true story, but the names and other details have been changed to protect reputations. Be assured, the thrust of the story and its implications are completely true. The Calm Before the Storm: A VC-Backed Company is Sold After years in business, a successful VC-backed company was on the verge of acquisition by a major global enterprise. Before the $250+ million deal could close, however, the selling shareholders are asked to appoint one of their own to serve without compensation as the shareholder representatives of the sellers. This is a common occurrence in most transactions involving sales of privately-held companies: One person is designated to speak and act on behalf of the former shareholders of the selling company in connection with issues that may arise after the closing. A reluctant but experienced VC agreed to take the job in order to get the transaction closed. She had been a shareholder representative in a few past deals, was a partner of a well-respected firm, and assumed there was little to no risk in doing the job. Months went by, and no claims were filed against the escrow. Predictably, the VC got busy with new projects and focused on helping current portfolio companies and looking for new deals, giving little thought to the closed transaction. A Critical Lapse Leads to Near Disaster While on a routine business trip, the VC’s office received a letter from the Buyer detailing an eight-figure claim against the escrow. A few days later, the VC returned to the office and began sorting through unopened mail, unreturned calls, and a backlog of emails and started attending to the usual fire drills and meetings. She quickly scanned the Buyer’s letter, noting with some annoyance that it was a large claim that seemed bogus at first glance, and made a mental note to respond to the claim in the next few days. A couple of weeks later, the VC was organizing her desk and came across the letter again, deciding this time to prepare a response disputing the claim. The VC completed the response, popped it in the overnight mail and forgot about it, figuring there might be a little back and forth but that in the end, the Buyer’s claim lacked any real merit. The next day, the phone rang – the Buyer was on the line. The VC listened in shock as the Buyer said that while they had received the letter, it had been delivered too late! It turned out that the Buyer had correctly started the 20-day clock when the letter was delivered to the VC’s firm, but the VC’s mental clock had started several days later, when she got back to the office. Therefore, under the terms of the merger agreement, her failure to respond to the claim within the designated time amounted to acceptance of the claim. The Buyer was entitled to seek immediate payment out of the escrow fund, which amounted to about 20% of the deal price. If the Buyer did demand payment, it would virtually wipe out the escrow fund and result in the VC’s firm and their investment partners losing tens of millions in expected returns from the deal. A Series of Terrible Phone Calls Notifying the other key parties to this transaction resulted in some phone calls no one wants to make. When she told the other investors in the deal about the situation, they responded by saying that they may have no choice but to sue the VC and her firm over the lost returns. The VC’s partners and the firm’s attorney then informed her that her own firm might have to sue her out of obligation to their limited partners. What About Indemnification and Insurance? Despite the bad news she received on the phone, the VC assumed she was covered for this mistake by the indemnification provisions of the merger agreement and insurance policies held by her firm and the target company. The target company had taken out a “Directors and Officers tail insurance” policy, and her firm carried “Errors and Omissions” coverage. What she didn’t yet fully appreciate is that the role of shareholder rep is a peculiar one. It requires the party taking on the role to assume some significant risks and responsibilities, but those risks aren’t easily covered by existing insurance policies and structures. In this case, the VC was far from properly protected. For starters, her critical mistake could be seen as gross negligence and a breach of her duty of care as the shareholder representative, nullifying the indemnification provisions in the merger agreement. The D&O tail policy was no help either. It only covered actions that occurred prior to the consummation of the merger and that were taken in the capacity of a director or officer of the target company. The failure to timely reply to the Buyer’s claim occurred after closing and was taken in her capacity as a shareholder representative rather than a director or officer, either one of which makes the D&O policy inapplicable. It was also unclear whether the firm’s E&O insurance would cover her actions since the role of shareholder representative is not directly tied to the operation or administration of a fund and was undertaken by her individually. Furthermore, even if the insurance did cover this situation, actions that constitute gross negligence are often carved out from such policies. Totaling Up the Damage If this escrow had been wiped out due to a claim with little to no merit simply because the VC acting as the shareholder representative failed to reply on time, it could have had dire consequences on the individual and the fund. First, the fund would have lost its pro rata portion of the escrow. This alone was a lot of money. Second, as noted above, the other former shareholders most likely would have filed suit against the shareholder representative for failing to meet her fiduciary obligations. Third, the fund’s limited partners may have sued the fund’s general partner entity for failure to properly manage the fund’s affairs or the fund may have sued the individual VC for breach of fiduciary duties to the funds’ partners. The suits and the related negative publicity could have had a range of negative consequences, from immediately bankrupting the fund and the individual to triggering a slow death by killing any ability to raise a new fund or otherwise continue as a VC. The Outcome: Dodging a Bullet In this case, the VC and the other shareholders were fortunate. They were able to persuade the Buyer to drop the claim based on its lack of merit and an argument that taking the millions of dollars in escrow – money that had been implicitly promised to the selling shareholders when the deal was struck – would have been poisonous to the culture of the combined entity. That was a lucky outcome and far from certain, because the Buyer had no legal obligation to cooperate as it did. The Lessons From This Near Miss
None of us thinks we will ever make a mistake like this, but who among us hasn’t missed a deadline after being distracted by other matters? The point is not that a VC made a big mistake. We all do. Rather, the lesson of this case study is that innocent mistakes made in the context of serving as a shareholder representative can have much great consequences than many people realize. With little to no upside to being the shareholder representative and no requirement that a VC take this job, one has to question why anyone would. Most Commented Posts |
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July 21st, 2009 at 2:00 pm
The shareholder’s rep was awfully lucky. Anyone who sets aside a letter from a lawyer making an 8 figure claim deserves to be sued. If I was returning to the office and saw that in my Inbox, it would get my top attention. Also, even when on vacation, most VCs check in with their office on the lookout for critical correspondence like this.
I’ve been a shareholders’ rep. I agree that it carries risks, as described. But, prompt attention to issues alleviates most of them. Most acquistions I have been involved with set aside a portion of the proceeds to fund a shareholders’ rep legal fund. This would enable the shareholders’ rep to consult counsel at a cost shared by all the shareholders. Doing that promptly in this case was required.
July 21st, 2009 at 4:42 pm
Scary story. You make a good case for why no one should take the job of shareholder’s representative, yet you say this is an argument for why a VC shouldn’t take it. If not a VC, who do you think should accept the responsibility?
As bad is it might have been for the VC firm, it could have been even worse for any other less protected or less well-heeled individual who took the role. If a VC who has a lot at stake won’t take the job, then why should anyone else?
I say this as the former CEO of a company that got bought. When it came time to appoint the shareholder’s rep, all the VCs around the table enthusiastically endorsed my having the honor. Now I know better than to accept the nomination next time.
July 21st, 2009 at 6:53 pm
Paul - your article is interesting and raises a real danger for VC’s when serving as shareholder reps. However it concerns me that at no point do you actually disclose that you work for a company that essentially does this function for venture backed startups. You essentially masked an advertisement under the guise of an article and did not even disclose you own biases. That’s very poor form and undermines your credibility.
July 22nd, 2009 at 1:28 am
This could be an exampe on the extreme. No doubt this is purely the mistake of the officer acting as shareholder rep. Firstly, there would normally be grace period and cure period for an event like this. No court would award such compensation based on pure time lapse, not to mention the escrow agent, who has to take every effort and action in order to protect itself should it wrongly release the escrow monies and later risk being sued. Secondly, escrow agent acts based on the terms provided in an escrow agreement. Neither buyer nor seller nor their lawyers would allow a clause in it to allow compensation claim based on time lapse. Thirdly, the article mentioned that it was subsequently dropped due to lack of merit. Can you imagine if the escrow had indeed released the monies, and the seller then sue the escrow agent for this “lack of merit”?? So in real life, this is a case study interpreted to the extreme. The take-away for this should be diligence and responsibility of the employee/officer involved must be of utmost importance.
July 22nd, 2009 at 9:44 am
Mak,
Thanks for the comment. I don’t think this interpretation of what could have happened here is as extreme as people might think. For instance, the applicable language of a merger agreement I just finished reviewing says:
If the Stockholder Representative shall not object in writing pursuant to Section 8.4(e) to any individual items of Loss set forth in an Officer’s Certificate delivered by Parent pursuant to Section 8.4(a) within twenty (20) calendar days after the Stockholder Representative’s receipt of such Officer’s Certificate, the Stockholder Representative shall be conclusively deemed to have acknowledged and irrevocably consented, for and on behalf of the Indemnifying Parties, (i) to the Indemnified Party recovery of the full amount of all such items of Loss set forth in such Officer’s Certificate, and (ii) if and to the extent necessary, and without further notice, to have stipulated to the entry of a final judgment for damages against the Indemnifying Parties for such items of Loss in any court having competent jurisdiction over the matter.
There is no cure period or wiggle room in that. Typical escrow agreements also say the bank has an unambiguous obligation to release the money if it doesn’t receive an objection letter within the applicable response period. You’re going into scary territory if you make the assumption that the courts are not going to enforce the clear terms of the agreements. The general rule on this is — you fail to reply, you lose.
Thanks again,
Paul
July 22nd, 2009 at 10:21 am
Frankly, i have to wonder about the fiduciary responsibility of the Buyer in this situation. What about the shareholders of the combined entity? Seems to me the Seller agreed to the terms of the deal when it signed the documents. The Buyer was entitled to the funds. Doesn’t the Buyer have a duty to its side to collect the monies it was legally entitled to?
July 22nd, 2009 at 11:05 am
I’m an M&A attorney and typically include shareholder rep. provisions in deals in which there are multiple selling stockholders. They are very useful in helping to support an orderly process for post-closing NWC adjustments and indemnity claims. With a few safeguards (not mentioned in your hypothetical), they’re also good for selling stockholders.
First, the notice provision in the purchase agreement almost always require that a copy of any indemnity claim letter also be sent to the selling stockholders’ attorney. As a result, for the situation you described to occur, the stockholder rep. must drop the ball and its attorney must also do so. This isn’t too likely, since the attorney will know that doing so is legal malpractice. I’ve helped buyers and sellers with many indemnity claims and I’m not aware of any situations in which the stockholder rep. tried to resolve an indemnity claim on his or her own - it’s a legal matter and counsel is always involved.
Second, stockholder rep. provision in the purchase agreement will usually require the other stockholders to indemnify the stockholder rep. for any losses resulting from him or her acting in that capacity. Although a gross negligence exception is sometimes included, that is a very difficult standard to satisfy, which requires the other stockholders to prove that the stockholder rep knowingly and intentionally disregarded its duties; an inadvertent oversight wouldn’t meet that standard.
Finally, when representing the buyer in M&A deals, I always include the “no response = claim conceded” language that you referenced and am usually successful in getting it included in the document, arguing that otherwise the selling stockholders have no incentive to promptly respond to the indemnity claim and negotiate an appropriate resolution with the buyer. However, when representing sellers, I have sometimes been successful in resisting such provisions. Usually the compromise is to require that multiple parties be included on the claim notice (which lessens the odds of it slipping through the cracks) and providing for a longer time period for the response — 20 days is quite short.
July 22nd, 2009 at 11:56 am
[...] Posted by newcompanylawyer on July 22, 2009 PE Hub had a great post today about the potential risks for VC funds (and individual VCs) serving as the stockholders’ representative for any future indemnification or escrow claims following the closing of the exit transaction. Â Click here to link to the article. [...]
July 22nd, 2009 at 12:12 pm
Interesting - cearly the casual attitude of the VC was a huge mistake, and she got off lucky in this case. Just goes to show how a slip can lead to an avalanche - but did not here it seems.
Probably a good lesson in priorities……. R.
July 22nd, 2009 at 12:16 pm
Although I’m sympathetic to making mistakes, this story represents a comedy of unnecessary, bone-head decisions:
First, you have a buyer investing in legal cycles of making an eight digit claim that they are willing to forgive due to “cultural” reasons - all I would take from this comedy of fools is no accountability expected here.
Second, you have a partner who accepts responsibility to carry her weight in SH rep duties that I’m sure is expected of all partners - or should be- and then fains the excuse of “too-busy” to manage the simplest of requirements. I agree w/ Mike here, anyone who ignores a letter like this person did deserves what she got and quite frankly, I’d question her judgment if I carried her E&O/SH liability policies.
Third, it appears that the buyer was found to being even more feckless by forgiving the claim without consideration.
Wow - hope I’m not one of their LPs.
July 22nd, 2009 at 9:17 pm
The lesson here seems to be to (1) take the role of shareholders’ representative quite seriously, and (2) involve competent legal counsel every step of the way until the deal is truly done.
Just what is a shareholders representative service anyway and why would someone ever outsource that role if it’s so clearly core to the selling shareholders’ fiduciary responsibility? Surely a VC responsible enough to be entrusted with tens/hundreds of millions of Limited Partner dollars can be counted upon to be trustworthy enough to sprint all the way through the finish line when they actually earn a return for those LPs?
July 22nd, 2009 at 11:30 pm
just.a.guy - it’s very unlikely that a shareholder would have a fiduciary obligation to agree to be the representative, but if the person does volunteer for the job, the fiduciary obligations and inherent risks kick in. Any VC or other stockholder considering taking the job has to think about those risks, the safeguards they’ll have in place, and whether this is the best use of their time. Many consider outsourcing if they are comfortable that the post-closing process will be well managed because it frees them up to find the next great deal rather than possibly getting bogged down in unforeseen disputes. Hope that helps.
July 23rd, 2009 at 2:51 pm
Exactly what kind of rocket science does it take to open your mail and respond in a timely manner? I fail to see the need to outsource competence.
July 31st, 2009 at 11:12 am
I agree with Venky. Is this a real story… or is the VC equivalent of a Penthouse Letter?