Is BitTorrent Blowing Up?

Four-year-old BitTorrent — whose free, open-source file-sharing applications are used by millions of people to distribute large software and media files — looks to be in some pretty grave trouble.

TechCrunch reported this morning that the company recently returned $17 million in funding that it had received last spring from Accel, DCM, and DAG Ventures. In a letter to shareholders, BitTorrent said that the move was made because it was “not gaining sufficient traction.”

BitTorrent more recently raised a drastically smaller round of $7 million at a “substantially reduced” valuation of $28 million. With the resized round, the San Francisco-based company has raised $36.25 million from its backers.

BitTorrent isn’t the first company to agree to unwind a funding, but it’s certainly not common, either. Foundry Group partner Jason Mendelson, a trained attorney who worked at Cooley Godward Kronish and then as general counsel for Mobius Venture Capital, tells me he’s only seen a “handful” of deals get undone in his career, saying that such dust-ups typically indicate that “this dog doesn’t hunt.”

I chatted with Mendelson earlier today about how protected VCs are from companies that don’t “gain sufficient traction.”

As an attorney who has crafted these funding agreements, is there typically an escape hatch that will allow a company’s VCs to back out under extraordinary conditions?

No, there are mechanisms like anti-dilution protections, so that if I buy stock at $2 dollars and someone comes in after me and buys the shares at $1 apiece, I can reprice mine, but escape hatches? No. When you see [what you’re seeing today with BitTorrent], it’s basically because you have these new investors — in this case, DAG Ventures — saying that I have all these other ways that I can make trouble. Do you want me as a friend or enemy? And the company of course voluntarily re-cuts the whole deal.

So there are no ways to back out of a financing once you’ve committed to it?

No quality company is going to agree to a clause that says, “if you don’t meet your milestones, we get to reprice the round.”

The only other mechanism you see are called material adverse change clauses, and you seem them sometimes in merger agreements — in other words, we’ll do this deal unless something blows up. In fact, in the merger world, they’re fairly standard. But in the financing world? No startup executives would agree to one. In part, [it’s impossible] because no one knows what an “adverse material change” is. It’s such a crapshoot. I’ve been involved in litigation involving material adverse changes and there are cases out there that are unpredictable such as  involving a radio station that lost 87 percent of its ad revenue a week before its merger was completed, and still a judge said: “You’re still on the airways. That’s not a material adverse change.”

No, in this case, I assume that DAG said: guess what? We’re re-recutting this deal, and everybody said OK.

What if there’s fraud involved?

If a company makes representations that turn out not to be true, your only recourse as a VC is to sue the company. There’s no automatic repricing mechanism. So even if BitTorrent said, “Here are the financials,” then later said, “opps, they aren’t right,” DAG’s option would have been to sue, the threat of which is really the gun to the head.

You’ve seen these financings get rescinded about five times as an attorney and a VC. What were the circumstances? Are there common threads?

In each case, the company was just as surprised by their performance as the VC. There wasn’t fraud, but in a very short time after the financing was done, it was apparent that XYZ didn’t happen. So I’ve seen these things happen in a collaborative and not adversarial way.

In the cases of these other companies, did they eventually go out of business?

As you can imagine, it never bodes well.