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After 38 years as a lawyer for the venture capital industry, Joseph Bartlett, a senior partner at Morrison & Foerster’s New York office, finds himself in a quandary. Bartlett, an authority on venture capital law and the author of several books, has for years represented the general partners of venture funds. But for the first time, the 69-year-old attorney is on the opposite side of the table, representing an investor, or limited partner, who wants out of its commitment. For now, he says his role is to advise the investor — an institution dominated by one individual — and try to hammer out a resolution without going to court. But the dispute defies easy solutions. “I’m ostensibly a big name in the business and this client came to me hoping that I can work things out,” he remarked in a recent interview. “The problem is, there is no magic solution, no rule book to go by. It’s hard — not impossible — but hard.” In these times of fund downsizings and negative returns, the venture capital industry is spawning a growing practice for lawyers coping with conflicts between disgruntled limited partners and beleaguered VCs. The pervasiveness of the disputes reflects just how tough the environment has become and how much more leverage investors now wield over VCs. To date, few institutional LPs have actually gone to the extent of filing suit against GPs for fear of damaging venture ties. The State of Connecticut v. Forstmann Little is perhaps the most visible case filed recently, along with suits by investors of Pasadena, Calif.’s idealab and investors of publicly traded meVC of San Francisco. Nonetheless, lawyers are poring over legal documents and exploring positions they’ve never had to deal with before. Some are analyzing the issues surrounding defaults or threatened defaults by the LPs. Others are busy scrutinizing the fine print of so-called clawback provisions in venture partnership agreements, where a general partner has to return some profits to limited partners if the GPs’ share exceeds a certain percentage of carried interest. “There’s a new cottage industry for lawyers in the venture world that’s looking with excruciating care at provisions in documents that were signed three or four years ago,” says Stephen Meredith, a partner at Edwards & Angell in Boston. “The limited partners are looking for loopholes to see if there’s any way to trigger clawback provisions earlier, and the general partners are looking at them to see what their potential economic exposure is.” Regardless of which side they represent, most lawyers, like Bartlett, typically end up trying to settle matters quietly because everyone agrees lawsuits are bad for business. Moreover, in many cases when the partnership agreements were drafted, no one anticipated the possibility of broad default. “The partnership agreements themselves don’t provide much relief for LPs in this market. They lock up capital and lock in the economics for a significant period of time and many of them were drafted during a much more robust market,” says Julie Allen of Proskauer Rose in New York. By all accounts, defaults are becoming widespread, but it is largely confined to the nouveau pauvre — formerly high-net-worth individuals — and corporate venture investors and large international groups that have scaled back their VC exposure, according to lawyers, secondary market experts and investors interviewed for this story. For instance, Japanese investment bank Nomura International pulled out from Israel’s Delta Ventures earlier this year, saying it was reducing its venture capital investments globally. So far, pension funds and endowments that contribute about 80 percent of the total venture capital pool show no signs of abandoning the asset class. “These investors are not bowing out, but it’s the individuals or family-owned LLC’s that got into the gravy train that are now jumping out,” says Mark Heesen, president of the National Venture Capital Association. Typically, investors default either because of liquidity problems or because they think they’re throwing good money after bad. After all, one-year returns for early-stage venture firms have been negative for the past four quarters. Last year, the share of high-net-worth individuals of the total VC pool dropped to 9 percent, or $3.6 billion, of the $40.6 billion raised from 12 percent, or $11 billion of the $105 billion raised in 2000 and $6 billion of the $60 billion funded in 1999, based on Venture Economics data. These limited partners don’t necessarily want to antagonize their general partners, and, likewise, no GP wants to rush out the door to declare an LP in default. But lawyers say that the teeth in the partnership provisions are not particularly strong. “The means for collecting on commitments are anemic when the prior capital investment has little of any value,” says Gregory Smith, a partner at Skadden, Arps, Slate, Meagher & Flom in Palo Alto, Calif. In nonhostile situations where the distressed LP informs the GP that he or she couldn’t make the next capital call because of liquidity problems, the GP usually seeks a third-party buyer. In most cases, this leads to a forced sale to a secondary market fund manager at a steep discount. Depending on the partnership agreements, the LPs may be subject to a penalty, such as a 50 percent devaluation of the equity interest. If, for instance, an LP invested $1 million in an initial capital payment and that has gone down in value to $500,000, the GP can cut that value further to $250,000 because the LP couldn’t make the next $1 million commitment. “We see everything from a 50 percent haircut on an LP’s capital account to a ban on participating in any future earnings or future capital contributions,” says Jedd Wider, an attorney at Orrick, Herrington & Sutcliffe of New York. In Bartlett’s case, the client isn’t a hardship case, but the group has decided it doesn’t want to continue investing in the venture fund. “There are a lot of cases like this and we just have to figure out a solution that doesn’t wind up in court. But, you know, one size doesn’t fit all,” Bartlett says. One option is for the GP to release the distressed LP of the commitment. But there’s always a danger that other LPs will ask for the same relief. “If word gets out, there’ll be a run on the bank,” Bartlett says. Things could get complicated when the venture fund is under water, or when the underlying portfolio investments appear to have dim prospects and no secondary buyer emerges. There’s clearly a real reluctance among the GPs to sue a defaulting LP because it could poison relationships and there is little prospect of collection from a distressed investor. But more importantly, according to one Silicon Valley lawyer who has represented both sides, the GPs are also afraid that if they pursue collections aggressively on capital commitments, they’ll get sued back with breach of fiduciary duty for the bad investments they made. The upshot is a Mexican standoff. “There’s a chilling effect going on here,” the lawyer says. In many cases, the venture capital managers are afraid of defaults, so they avoid that by not making a capital call until the situation is resolved with the potentially defaulting parties. “No call, no default,” he says. This could account, at least in part, for the slow pace of investments by many venture funds. These behind-the-scenes conflicts rarely surface publicly, but when they do, it’s high drama. Eric Greenberg, founder of once high-flying Internet consulting companies Scient Inc. of New York and Boston’s Viant Corp. and a high-profile investor of Benchmark Capital of Menlo Park, Calif., spoke out in March to lambaste the Silicon Valley firm, saying its record “was littered with flameouts that should never have been funded and never gone public.” Greenberg told Red Herring magazine that he has asked to be released from his partnership interests from Benchmark’s Europe fund, as well as from two other firms, San Francisco’s Angel Investors and Seattle-based Maveron. Evidently, Greenberg and Benchmark haven’t seen eye to eye since the unspectacular flameout last year of their Internet incubator joint venture, 12 Entrepeneuring. Benchmark reportedly hasn’t accommodated Greenberg’s request, but no lawsuits have been filed — yet. Benchmark declined to comment for this story. Greenberg could not be reached for comment. Prickly issues related to outsized funds and management fees continue to be debated in the industry, even as the number of megafunds has dwindled amid lower valuations. LPs tend to give their GPs credit for compromise, voluntarily cutting back the size of many funds and in some cases reducing management fees. For instance, when Palo Alto, Calif.-based Accel Partners proposed to split its $1.4 billion eighth fund in two, many investors expressed their discomfort with locking in their commitment to a second fund several years in advance of its being invested. Thus, despite the fact that LPs approved the split, the firm opted to reduce the size of the fund to $950 million. “So far, we haven’t gotten into problems with any of our GPs,” says Clint Harris, managing partner at Grove Street Advisors of Wellesley, Mass., which manages about $3 billion and has invested in about 110 funds. Although there were potentially contentious situations with two unnamed venture funds, he says these were resolved amicably. In one case, the key partner orchestrating the questionable fund strategy left the firm. In the other, the fund in question was an affiliate of a larger fund, both backed by the same parent. When the parent divorced itself from the affiliate fund, the fund stopped drawing down capital commitments and restructured. Its limited partners were given the choice of opting out of the new fund. With returns way down, some LPs are unhappy that GPs of some funds collected profits in the early stages, before the market turned sour. The LPs are thus poring over clawback clauses that require VCs to pay some of their profits back if long-term returns are lower than anticipated. Generally, the incentive provisions in venture partnership agreements entitle GPs to take out their carried interest, or percentage of profits, before the LPs get all their money back. With many Internet funds, GPs had plenty of realizations or exits early in the life of their funds that led to cash and stock distributions to the GPs even before any capital was returned to the LPs. The average life of a fund is 10 years but the clawback doesn’t kick in until the fund’s life ends. When returns on the later years are not sufficient to support the carried interest the GPs already collected, LPs are entitled to “claw back” and go after the GP. But having the right to a clawback is one thing; collecting is another. “The problem may be that because a fund is doing so poorly, some of the GPs actually have left, and just tracing them and finding the money might be hard,” says Edward Reilly, a New York-based partner at Morgan Lewis & Bockius. Another problem arises when the GP is not an individual partner but a shell entity, such as a limited liability company or another partnership. “You may have situations where the GP of the fund is obligated to return the money to the fund, but the GP no longer has the money because it has distributed the money to the individual owners of the GP,” Meredith says. “And even if those individuals have signed something obligating them to return the distributions to the GP to enable the GP to honor the clawback, they may have already spent it on fancy houses or more bad Internet investments.” In other cases, some of the individuals may be good for the money but others are not. “So you get in situations where individual GPs can actually have fights among themselves,” says Meredith. It all depends on the terms, but, he adds, “Sometimes, one of the GPs can have deep pockets and another one has pissed all his money away, so the one with the deep pocket is forced to give back more money than he actually received in order to make good on the guarantee.” With such bad underlying investment results and so little legal precedent, not everyone is pleased with the outcomes of the tense negotiations between GPs and LPs. But the uneasy dance is usually better than slugging out in court. Like others, Bartlett cautions against hiring the “high-octane, sue-the-bastards lawyers” who can destroy the value of funds that may have fragile little companies in their portfolios. Though still uncertain how his case will end up, Bartlett says he’s willing to give anything a try. “Each of these solutions are ad hoc,” he says. “Maybe my client will take a bit of a penalty cut, maybe not. It’s a trading situation.” Copyright �2002 TDD, LLC. All rights reserved.

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