It’s an age-old story: Entrepreneurs meet VCs. VCs fund entrepreneurs. Entrepreneurs’ get washed out. VCs get sued by entrepreneurs.
The latest chapter is being written by two co-founders of Rapt Inc., a San Francisco-based provider of price optimization and profitability management solutions. They are suing Rapt backers Accel Partners and Levensohn Venture Partners – plus Rapt’s third co-founder and current CEO – for breach of fiduciary duty and fraud. The two sides are scheduled for a case management conference later this month, and a settlement is likely. After all, no similar case in recent memory has actually progressed to trial. If this is the exception, however, smart money is on Accel and Levensohn prevailing.
The case is justly referred to as complex civil litigation, because there are a large number of moving parts. So please bear with me as I try summarizing chronologically, as told in the complaint:
- Rapt was founded in 1998 by Adam Galper, Paul Dagum and Tom Chavez. They raised their first outside funding in 1999, with a convertible note financing led by Bristol Investment Co. (also a plaintiff). The deal meant that the three co-founders and Bristol all would hold Rapt common stock.
- In July 1999, Rapt raised $4.7 million in Series A preferred funding at a $6 million pre-money valuation ($0.44 per share), led by Accel Partners. Arthur Patterson of Accel was named company chairman. In May 2000, Rapt raised $27.8 million in Series B preferred funding, at a pre-money valuation of $80 million ($2.78 per share). Summit Partners led, with Accel following on. Kip Sheeline of Summit took a board seat. Five months later, Galper left to pursue other ventures (he currently is CTO of XTime). The compliant alleges that the departure was largely due to disagreements between Galper and CEO Tom Chavez.
- In March 2002, Rapt raised $9.13 million in Series C funding at a pre-money valuation of $32 million ($0.83 per share). The down-round was largely due to the preceding bubble burst, and Levensohn Venture Partners came aboard as a new lead investor (Kip Sheeline had since joined Levensohn, and kept his seat). In January 2004, Rapt raised around $5 million in a convertible bridge loan from existing preferred shareholders.
- Paul Dagum (chief science officer) and Tom Chavez (CEO) also had numerous run-ins, and Dagum indicated a desire to leave in May 2004. According to the complaint, both Chavez and Patterson warned Dagum that he would be leaving a lot of money on the table, and that his departure would result in his existing common stock being “smashed” down (i.e. severely diluted). Dagum left anyway.
- The Series D round seems to have held multiple closes in late 2005 and early 2006, at a pre-money valuation of just $35 million ($0.132 per share). The deal also included a provision whereby preferred shareholders would receive 9 common shares for each held share of Series A or Series B stock, and 12 common shares for each Series C share. The result was a massive dilution of common equity holders. This included company employees, but they were later “made whole” by the distribution of even more common stock.
- Galper and Dagum believe that the Series D round breached fiduciary duty to common shareholders, and also feel that the deal was primarily transacted for the purpose of retaliation. Rapt, they argue, had little need for additional financing, and any Series D round should have come at an increased valuation from Series C (based, in part, on revenue). Moreover, they accuse Accel and Levensohn of basically closing the deal before soliciting shareholder approval – while also providing Chavez with a carve-out so that he wouldn’t get similarly washed-out.
Assume, for a moment, that the primary complaint is valid: That Accel and Levensohn truly were angry at Dagum for bailing, and exacted revenge via a recap. Clearly an immoral move, but not necessarily an illegal one. There is a strong case to be made that a company is best off when incentivizing current employees. As such, it could have been in Rapt’s interest to dilute former employees like Galper and Dagum, to the benefit of current employees and directors.
Let’s move on to the assertion that Rapt didn’t need extra cash, let alone an insider round. I don’t have access to the pertinent financials, but it is worth noting that Summit Partners did not participate in the Series D. In fact, Summit had essentially written off its entire investment by late last year. If Rapt was truly such a strong concern – as Galper and Dagum allege – why would an existing preferred shareholder (with deep pockets) not participate pro rata in a pro rata recap? Summit isn’t talking, but the only logical explanation is that they thought Rapt was a lost cause.
Finally, there is the matter of fraud. This is the only place I see possible trouble for the defendants, since the complaint alleges that both they and employees were essentially lied to about the status and consequences of the Series D round. Under California law, however, a company does not have to preemptively solicit consent from all shareholders for a material event, so long as all shareholders are eventually informed.
The reality here is that two company founders got the short end of their own sweat-stained stick. It should be a cautionary tale for entrepreneurs who could get bank loans in lieu of venture capital. Galper and Dagum either didn’t have participation rights, or couldn’t afford the pro rata participation anyway. Either way, they certainly have the right to be disgruntled. I just don’t think they have the right to a positive verdict.
I contacted Galper, Dagum, their attorneys, Accel (Patterson and Jim Breyer) and Levensohn (Sheeline and Pascal Levensohn). None were willing to comment. Also, thanks to my colleague Alex Haislip for both getting the actual complaint from the San Mateo courthouse, and for playing devil’s advocate with me (he changed my mind).