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In August of last year, Scott Hyten was on top of the world. The Austin, Texas, venture capitalist had just launched Eco Associates to invest in distressed Internet companies. He planned on raising $200 million with the help of Steve Hicks, head of Capstar Partners and brother of Tom Hicks, chief of Dallas private equity giant Hicks, Muse, Tate & Furst Inc. His plan, well documented in the financial press, was to invest in 10 to 12 companies by the end of 2000. “By outsourcing the core technologies of struggling dot-coms in which we invest, we’re confident that costs can be lowered by 50 percent to 70 percent,” Hyten said at the time. “That will provide the time and flexibility needed to properly execute their business plans.” Things haven’t worked out as Hyten planned. He was only able to raise about $100 million. He invested in about eight companies. And one of his portfolio companies, Urban Box Office Network Inc., which operated an online hip-hop music site in New York, even sued him last December for not providing the company $20 million in promised funding. Now Hyten’s own investors are suing him. On July 13, one group, mainly from the Austin area, filed a lawsuit against Hyten, claiming that he, his venture capital firm, Interfase Capital Partners, and Hicks misapplied more than $7 million in funds, mainly in a troubled Internet retailer called Mall.com. ALLEGATIONS OF FRAUD Two weeks later, the investors filed a second, potentially more damaging lawsuit, this time charging four counts of securities fraud. The document contains much more detail about how Hyten and Hicks allegedly raised funds, made false statements to investors and invested in other companies without approval from the limited partners. The investors have hired some big guns to represent them: Jim George of George & Donaldson in Austin. George is considered one of the best business litigators in the state. A University of Texas law graduate who clerked for U.S. Supreme Court Justice Thurgood Marshall, he recently won a rare legal malpractice suit against the legal advisers of a failed foreign currency exchange business, Austin Forex International, arguing that the advisers knew its founder was defrauding investors and did nothing to stop it. George’s firm has recovered millions of dollars for clients in the ongoing class action suit. Since the lawsuits were filed, Hyten has closed Interfase’s suite of office space in Austin, although a spokesman says he continues to run the firm. John Hughes, a business and technology attorney at Boston’s Hutchins Wheeler & Dittmar, said the suits are a little out of the ordinary. “It’s unusual in that investors are claiming they invested in a fund based on the representation of the venture capital firm that it would invest in a certain company rather than a certain class of investment,” he said. “Usually a fund is raised, and there’s a general focus for the fund. Usually, potential companies that money is going to be invested in are unidentified.” DAMAGING PICTURE Through his spokesman, Hyten wouldn’t comment on the two lawsuits, and he has yet to file his response to the courts (other defendants have responded, denying the charges, with some asserting their right to arbitration). But the complaints paint a damaging picture of what venture capitalists do with other people’s money. According to the original petition, Hyten, a former executive at Dallas information technology consulting firm Perot Systems Inc., decided to form a venture capital firm in early 1999 to invest in start-up companies whose business involved the Internet. He enlisted the help of co-defendants Timothy Timmerman and Ronald Carroll to help raise money. By fall 1999, Jon Rex Jones Jr. and his father, Jon Rex Jones Sr. and uncle A.J. Jones, Albany, Tex., investors in the energy sector, joined in to help raise money and operate the funds. The first fund, Interfase Capital Partners, raised almost $8.5 million; the defendants claim it was supposed to invest in only one company, Wild Brain Inc., a privately held animation content provider in San Francisco. It did just that in August of 1999, investing $6.5 million. Wild Brain had great prospects. Founded in 1994 by three guys in the basement of an old Victorian house and financed with $15,000, Wild Brain already had a list of clients that included Microsoft Corp., Universal Studios, Intel Corp., Twentieth Century Fox, Coca-Cola Co., Warner Bros., Xerox Corp., Walt Disney Co. and Silicon Graphics Inc. The investment allowed it to develop a Web initiative, including its Internet animation channel, wildbrain.com, in December 1999. “We are excited about the opportunity to invest in this exceptional independent animation studio,” Hyten said at the time. Interfase invested another $20 million in Wild Brain in May 2000, along with Franz von Auersperg, founding board member of German entertainment giant EM.TV (recent purchasers of The Jim Henson Co. in the United States), and Hicks, who joined Wild Brain’s board of directors. “I am excited about assisting Wild Brain in their development into one of the leading new media companies in the world,” Hicks said. LOST MONEY By the end of 2000, Interfase had five funds: Interfase Capital Partners I, II, III, IV and the Eco Opportunity Fund. The suit claims that each fund was supposed to operate separately and independently and none was authorized to loan money to Mall.com. The suit charges the defendants raised $40 million and lost all of it. According to the lawsuit, Hicks came on the scene in early 2000, when he approached Hyten about buying an interest in Interfase Capital Managers, the general partner of Fund I and Fund III, which had been formed to invest in Wild Brain. Hicks and his entities, Capstar Partners and Capstar Investment Partners, became limited partners in some of the Interfase limited partnerships. At the same time, Hicks was also investing in Mall.com, which was in serious financial trouble. According to the complaint, Hicks had been issued a number of options to buy Mall.com stock at favorable prices, and was named chairman of the board in exchange for his help in securing financing. According to the complaint, Hicks also wanted to invest in the other general partners of the funds as a way of convincing their backers to invest in Mall.com. He also said he would help the investors raise a $200 million venture capital fund that would be associated with his more famous brother, Tom Hicks of Dallas private equity firm Hicks, Muse, Tate & Furst. AUTHORIZATION IN DOUBT The investors claim Hicks used the lure of the new large fund to help persuade them to loan Mall.com money — $5 million by February of this year. They say none of the loans was authorized by the limited partnership fund agreements, and that they had been sold their interest on the specific representation that their money would be invested in or for the benefit of other companies. That’s not all. The investors claim Hyten lent himself and his entity, Full Cry Partners, $700,000 for “general partnership operating expenses.” The loan was authorized by Jones, Timmerman and Carroll — but not by the limited partnerships, they allege. Finally, the suit charges, Hyten also gave $3 million of the funds’ money to Urban Box Office, which operated the UBO.net hip-hop Web site. The investors claim Urban Box Office was insolvent and on the verge of bankruptcy, and the money was handed to the firm without “meaningful security.” “The funds were almost immediately lost and created a situation that resulted in Urban Box Office suing the funds for $20 million,” the complaint says. Indeed, last December, Urban Box Office sued Interfase Capital Partners and Eco Opportunity Fund, maintaining they reneged on a signed stock-purchase agreement that would have provided the firm with $20 million of an anticipated $35 million Series D financing round last summer. When the money didn’t come, Urban Box Office claims it was forced to shut down, lay off its 300 employees and file for bankruptcy. Urban Box Office is represented by Michael Chodos, in Palos Verdes Estates, Calif., and Jonathan Wolfert at Kaplan, Thomashower & Landau of New York. Interfase has countered that the funding round was predicated upon certain requirements, such as strategic partnerships that the company said were imminent and additional revenue streams that were not met. INVESTOR-LED SUITS The investors are not only asking to cover $7.5 million in damages, they’re also asking for Hyten, Hicks and the others to pay reasonable costs and attorneys’ fees and exemplary damages as well as give them an order that they indemnify the funds from claims by Urban Box Office. In the second suit, the investors are looking for their $5 million investment back or damages “for their harm” as well as attorneys’ fees and costs. Whatever happens with the suits, Hughes expects more investor-led complaints like the one filed against Interfase to come to the forefront. “What I anticipate seeing is claims by investors that venture capital firms were negligent in making investment decisions,” he said. “Limited partnership agreements exclude liability from sheer negligence. But given the frequency the dot-com businesses are crashing and burning, investors who have gotten stung will look for creative ways to get around those limitations.” Copyright (c)2001 TDD, LLC. All rights reserved.

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