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
- Anyone, but especially venture capitalists who have fiduciary responsibilities to their partners, should consider very carefully whether they want to take on the role of serving as a shareholder representative. There is very little upside in such position, and as this case study makes clear, the downside risk, while low in probability, can have a devastating impact.
- Limited partners that invest in venture firms should also consider whether they want to allow the partners in the funds in which they invest to serve as shareholder representatives for the same reasons.
- The individual partner who is considering signing on for this job should weigh the personal exposure and responsibility he or she may be accepting. At a minimum, this person should fully understand what is covered by applicable insurance policies and think about potential consequences of innocent mistakes such as the one described in this case study.
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.