Jul 27 2011

Beware of ASSHOLE VCs

Before Foundry makes an investment we perform extensive due diligence. We meet with various company managers, talk to other people in industry to get their take, call current and prospective customers, exercise our own network of contacts to get background on the idea and team, perform reference checks on key management, etc. While this process varies, we’re always diligent before entering into what we view as a long term partnership with the company.

What more and more entrepreneurs are realizing is that they should be doing the same kind of due diligence on their potential funders.

We’ve been long time fans of this kind of reverse due diligence and always encourage entrepreneurs to “check us out” before making a decision to invest with us. My partners and I all have blogs which I think are good indications of our varied personalities, but we also provide a list of references (CEOs, other portfolio execs, other people who know us well) for them to look into how we really are to work with.

It’s particularly important to find a few reference points for deals that didn’t go well. You really learn about someone’s true character in those situations.

I was reminded of this fact recently. Through various activities (mostly pre-dating the formation of Foundry Group), I’m a shareholder in a number of non-Foundry related companies. One of those recently sold off a significant piece of technology for quite a bit money. The business has raised a lot of capital and struggled at times, but selling off this technology and continuing to focus on the additional technology that was to remain in the business, was a major step for the company. As a common shareholder my first reaction was “great; this deal will reduce the preference overhang on the business and there’s still some really interesting potential upside with the remaining asset.”

Sadly, I forgot the golden rule of venture: MANY VCs ARE ASSHOLES

Not all that shockingly, given who the VCs are in this case, they decided that – magically – this sale of a portion of the company’s assets could be convoluted into a liquidation of the entire business (a technical definition that relates to language in the charter and the “judgement” of the board). This helped them with a number of things. First – they achieved a significantly better tax outcome on the distribution of proceeds. More importantly, this handily resulted in their ability to completely wipe out the common ownership in the business. That’s right. Instead of paying down the preference and leaving the common in their rightful place – better off for having paid off a significant portion of the preference overhang on the business – these ASSHOLE VCs instead decided to take the opportunity to not only pay back a substantial portion of their investment but also to cut the common completely out of the cap table.

Aren’t there lawyers involved? How could they let this happen?

Here’s where working with ASSHOLE VCs really screws with you. Company counsel is a very well known valley firm. They do a LOT of work for these ASSHOLE VCs. So when it came down to it, they were on the side of the investors not the company.

How about the common shareholders? Couldn’t they do anything?

Well, unfortunately (and I am actually pretty sympathetic here), the vast majority of the common was held by the management of the business. And thanks to a (not particularly generous) carve-out program for management, these ASSHOLE VCs were able to hold their vote ransom. “We’ll push this through either way,” I suspect they said, “so either vote with us and at least get a cut of the proceeds in the form of this bonus or vote against us and lose it all.” And really management had no great choice.

The irony here from my perspective is that it actually wasn’t even a very smart economic move by the investors involved (ASSHOLE VCs aren’t always that smart). If it turns out that the company was worth quite a bit, the common shareholders will surely sue for their fair share (I will likely be at the front of that line). If it’s not, then there was no skin off their back to begin with. Of course there is a matter of the statute of limitations (even fraud, which I believe this is, has a time window for action), so there is some outside chance that they’ll rip everyone off and get away scott free.  Of course I’ll know who they are… (there’s a long story about why I’m not going after them now which isn’t something I can get into here; it’s the same reason I’m not just calling them out in this post by name).

So the moral of the story is: check out your investors before you go into business with them. They may dress in smart looking khakis and polo shirts; they may have fancy offices on Sand Hill Road and drive hybrid cars; but they may also be ASSHOLE VCs. And that would be bad for your business.