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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.

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July 27th, 2011     Categories: Uncategorized     Tags: ,
  • Aa

    “given who the VCs are in this case, they decided that”

    Why not just call them out by name?

    • Guestivus

      Ever read Founders at Work?  Inventors of web-based email (a little product called Hotmail, if you’ve ever head of it) named names.  DLJ screwed them and the editors of the book (Y-Combinator) weren’t afraid to keep it in print.  That was refreshing to see.

      • http://www.charliecrystle.com Charlie Crystle

        DFJ, not DLJ. How did they ‘screw’ them?

    • Steve Schultz

      my thoughts exactly. the reason these ASSHOLE VCs are able to continue to get away with being ASSHOLE VCs is that there’s no social cost. call them out! that’s how we, the entrepreneurs, can get the info we need to make good decisions!

  • http://paulroales.com PaulRoales

    Or how about retitle this post “get lawyers that truly work for you..”

  • http://twitter.com/ReplytoAll Robert Pease

    Awesome post Seth.  Especially like the use of images at the end…

  • pj

    Seth, what is “preference overhang”? Does this refer to the guarantueed dividends (paid out at liquidity event) preferred stock sometimes has?

    • http://bizen.com Jackson Miller

      Thanks for asking that. I mademthe same assumption, but it would be nice to know for sure.

    • http://twitter.com/adaugelli Adam D’Augelli

      Preference overhang refers to the fact that in a liquidation event different types of securities will be paid back in full before other classes of securities see any return.

      In general: Debt will be paid back before preferred stock before common stock.

      For example, assume that there is a single preferred class of stock who has invested $5m into the business and owns 30% of the company.  Following the situation above, the company sells the asset and has $3m of remaining cash on the balance sheet (and no outstanding debt.)

      Rather than split the cash 70 / 30 – the investors will receive then entire cash balance of $3 (and would have a similar result up until the preferred is completely paid back) 

  • http://twitter.com/danielpalacio danielpalacio

    Forget the VC’s, who are the lawyers ? Being asshole is bad but not illegal, not giving proper counsel as a lawyer is.

    • http://www.websterisk.com Josh Webb

      When lawyers get in to this situation, you usually end up signing something that says “I understand that my legal team has a peripheral conflict of interest. They have alerted me to this fact and I have decided to continue allowing them to represent me. I give up my rights to using this fact against them at a later date” (I am not a lawyer, I am not your (or their) lawyer, I am not a lawyer in whatever state this happened in, but this is something that can happen). That type of unfortunate circumstance probably keeps them in good shape with the Bar Association on this offense.

      If only you could dis-bar someone for being asshole.

  • http://pulse.yahoo.com/_TPZ4OQFFG7EIGSK7752LGC3NKU Bernal

    In the 80′s I was hired at a VC fund in San Francisco.  We were a department of an investment bank, and our main purpose was to generate banking business for the firm; returns to the investors were a distant second, and the success or failure of the companies wasn’t important at all.  After a year our reputation got around, and companies would accept our money only as a last resort.  We had a few investors who were famous figures in tech, and they really truly hated us and our treacherous ways.  So anyway, yeah, there are terrible VCs.  The thing to do is get someone on your board, pre-VC, who has gone through it before, and who is able to be honest about the terms of deals, who won’t just be blinded by the money.  I moved to the other side of the table, and found that lots of people in tech, who are otherwise quite intelligent, never even read the terms of their own funding agreements.  Or they read them, notice the potential terrible outcomes, and naively assume that the VCs would never go down those paths.  I always read all the funding documents before considering joining a company; it was considered weird and inappropriate by some people, but I turned down a couple of offers based on the VC situation, and was later glad that I did.

  • Jtaylor

    So how does this help us prevent the problem in any way?

    • Jtaylor

      Said this given that the author  didn’t name the firm or law firm how it’s not like they would give your company as a reference

  • http://www.cdixon.org chris dixon

    I’ve discovered the hard way that there are a thousand ways you can get screwed as an angel investor (and management – although that hasn’t happened to me personally).  I’m an angel investor in a company that brought on a new CEO that doesn’t know the angels and then they did a deal with a VC and issued a ~70% option pool to management.  It was constructed solely to wash out the angels who by the way invested at the bottom of the market in 2008 when no one else would invest.  I suppose we could sue but who wants to go through that so we are trying to just get them to return our money. 

    • http://twitter.com/zibbyz Pamela Day

      I would hope that what comes around goes around – that this new CEO (and management team).  Will be blacklisted, for screwing an Angel who took an extra risk.  
      Solid entrepreneurs are very aware of relationships and risk, knowing that the ‘value’ of an investor who will step in at the bottom of the market is worth more, on multiple levels than a VC who drops in when all is well.

      • http://www.kartme.com Phil Michaelson

        Like @twitter-15924411:disqus, I’m surprised this can happen. I’d think more people view entrepreneurship/investing as a game played repeatedly, where you wouldn’t want to ruin future chances.

      • Joe Davy

        Unfortunately, in cases like this, people allow their personal interests to outweigh the best interest of their shareholders and the people that have helped get them where they are. The reality is that for many “Mercenary CEOs”, parachuting in, then helping a later-stage VC investor make 30% more money at the expense of the Angel investors is potentially in the best interest of their career (and wallet).

        By compromising what’s right for short term profit, they strengthen their resume and relationship with (a segment of) the VC community, and will probably be able to raise a lot more money down the road from the same or similar VCs. Management can often be convinced to go along for the ride, knowing that they’ll probably make out fairly well.

        It’s these situations where your values truly shine. To an entrepreneur starting companies, Angel investors are critically important… early on. But over time, they often loose power and influence over the future of the company.

        Your character isn’t defined by what you’re willing to do for someone when you need their help. It’s defined by what you’re willing to do when nobody is watching.

        Unfortunately, this kind of behavior is so prevalent that many would-be early-stage investors have become disillusioned with traditional angel investing, opting instead fo put their money in angel “funds” or join as LPs in mega-funds that include seed programs. Or worse yet, to just keep their money in their Schwab account.

    • http://www.justanentrrepreneur.com Philip Sugar

      Like your comment.  This has been happening since the early 90′s.  It wasn’t too bad back then, got awful in the dot.com implosion, and I fear will be even worse when today’s froth melts.

  • http://twitter.com/3DeeQuotes Deepak Patel

    Great post Seth :)
    The problem in such instances is that while its easy for the VC’s to do a reference check on the entrepreneurs, it gets too difficult at times for the entrepreneurs to run a reverse due diligence on their potential funders. Thus falling into the trap!

    • Guest

       Totally agree!

  • Oliver Jones

    Thanks for this.

    To say that VC’s take the money and run, even if they could have had more money later by staying, is like saying that cats kill mice.  It’s what they do.  If their funding comes from pension funds and other institutions, they’re measured on internal rate of return, which pushes them to extract their value sooner rather than later when possible.

    Also: the lawyers they recommend to represent the company work for the BOARD, not the individuals in management. And the BOARD represents the SHAREHOLDERS.  The majority of shareholders are often VCs.  So, expecting the law firm papering a deal to represent the common shareholders is like expecting a cat to be vegetarian.

    If an entrepreneur wants a lawyer working for her, she has to hire one. It’s not terribly expensive (a couple of kilobucks) to hire a lawyer to review a term sheet and the followon paperwork.  The lawyer will tell her, “this is fair and that isn’t.” She can then decide what to do about it, if anything.  Her choices are: walk away from the deal, negotiate, or sign anyway.  If the entrepreneur decides to negotiate, she can do it herself or ask the lawyer to help.  

    One thing to ask about in due diligence is whether the VCs have worked with the same entrepreneurs more than once.  Do they have people — both at the management level and at the next level down — who have been in more than one of their portfolio companies?  Some VCs take pride in this.  If they’re successful at it, it’s a good sign they care about the teams in their companies.

    Another thing to investigate is the quality of executives these VCs have hired into their portfolio companies.  At least some of the people that get hired as CEOs into early stage companies post-money are pretty awful. There are stories about stuff like college tuition payments on company credit cards that can freeze your ‘nads in midsummer.  Ask about this.

  • http://www.facebook.com/oyaron Yaron Orenstein

    This is a great post, which should be read by every entrepreneur but it will be much more helpful if you just told us the name of the VC. Its like saying, watch out of the police trap outside without giving us the exact location.

  • http://hdemott.wordpress.com Harry DeMott

    I suppose you could have entitled this “The Tragedy Of The Commons” – would have appealed to Chris Dixon below!

    I am assuming that the a$$hole VC’s know that you are an investor and therefore feel that they have no need for Foundry anytime in the future.

    I also assume that they have a lot of D&O Insurance at the board level – for as you say – if there’s any juice in the lemon – you and the rest of the non management common shareholders will be right back at the court.

  • http://hdemott.wordpress.com Harry DeMott

    You might have appealed to chris Dixon below by renaming this post “The Tragedy of the Commons.”

    I assume the A$$HOLE VC’s know that you are an investor and thus feel they will never need anything from foundry. It’s a small world out there.

    Also, I assume the board has a lot of D&O Insurance. If there’s more value in the company – you and the other management shareholders will be right back in court. Fraudulent conveyance? Disgorgement of incentive fees? Public battle played out on the pages of the blogosphere?

    None of that is good.

  • Steve Perryman

    Great Post

    Right on the money (Theirs …)
    I am a CEO of start up – and I had a similar situation – Investors put it straight forward – either you are with us or…..  I had to go along with them (or else the management and emp stock would be toilet paper)
    Additionally, the upside that they offered was not exactly satisfying.
    Same thing was with legal (as in your recollection) 

    Seems the assholes are always there – its just the name of the VC that changes…….

    Steve

    PS – I totally agree and recommend that we (entrepreneurs) should DD investors 

  • Anonymous

    If this VC offered a term sheet, and I did due diligence on them, I would never know about their shenanigans, because YOU DIDN’T TELL ANYBODY!

    How are we supposed to perform due diligence on VCs if everyone they screw, including you, is silent?

    • http://GeekAtSea.com/?utm_source=disqus&utm_medium=display_name&utm_campaign=disqus_display Kirill Zubovsky

      It’d take a guess here, but I suspect that if you (or I) knew Seth in person, or at least through a 2nd degree connection, you’d be able to find out who these guys are. Secondary, there aren’t that many prominent VCs on Sand Hill Road … go figure. After all, it’s your job to do the due diligence  and if you can’t figure out where to find the right information, then maybe you should be doing something else.

  • Spill The Beans

    Great post. 
    When I was in the process of raising VC money and was close to a term sheet the Partner I was working with gave me a list of CEO’s to call. One thing I learned was to read between the lines of what these CEO’s were saying. Not a single one said he was a good investor, rather the comment was he is always available to discuss issues. 
    When I pressed further to hear how he interacts with other Board members the response was he will vote with other VC’s and turn on you in a second. 

    Not surprisingly the day he was to issue the term sheet he pulled out of the deal and screwed us by lying about why he couldn’t do the deal. 
    VC’s need to remember the Entrepreneurs do speak and smart entrepreneurs do their diligence prior to hiring employees, signing customers, closing partnerships, and raising money. 

    Saying VC’s are assholes is a bit much of a generalization but naming the VC would insure they stop f$%&ing companies in the future. 

    • Royi G.

      What’s with this chicken shit cowardly response? If you feel so strongly that this VC screwed you, why aren’t you helping prevent them from screwing others. Name some names. This whole post and thread sucks as no one is really helping anyone here other than stating the obvious. I think most VCs and startups invested by VCs are a cowardly lot.

  • Peter

    The core problem is that people won’t name asshole VCs. It’s always to your interest to be positive about people, so this virtually never happens. I read a post like this. I know asshole VCs exist. You won’t name them. No one else will either. I don’t know who they are. 

    • Me

      Join TheFunded and you’ll hear a lot of stories where names are named. 

      • Gary Sevounts

        I think The Funded does a good job calling out asshole VCs and to a degree leveling the field for entrepreneurs.  It is great to be able to read a review on not just the VC, but a specific partner.  Given, these can be subjective (and vindictive at times), but the site gives you a good general idea. 

        • http://www.sethlevine.com sethlevine

          Your point on specific partners is a good one – and works in both directions (bad firms can have good partners, but good firms can also have partners that are difficult to work with). Funded is an ok source, although I think tends to float to the extremes a bit.

  • http://twitter.com/LDEakman LD Eakman

    We run across A LOT of asshole VCs, with just a bit of work you can find their reputation quickly.  Funny thing is that most people don’t even make that extra call.  I think I now see why you were losing your mind last week.  Great finger graphic.   Let me know if it’s one of our VCs, happy to send on your regards. 

  • http://twitter.com/mediainvestors Ted Carroll

    Yup, an ugly situation Seth. Something like this happened to our firm back in the 1987 era when cleverly obfuscated wording in a preference waterfall caused what we felt was a fraudulent transfer of interests. They didn’t earn it, they stole it. The real “payback” for this came over time – as investors checked in about the fantastic value we had identified and then surfaced. We just told them the sequence of activities and decisions and, to the brighter questioners, the case became clear. Like us, your time for this will come. BTW the key bad actors (one a VC and one a prestigious law firm partner) in our story later came to grief. Reputations are such fragile things.

  • http://getabl.wordpress.com/ markslater

    thanks for the authentic rant seth. 

    God i hate it when you lot write these stories without naming names! its like reading a bad suspense thriller with no happy ending. 

    joking aside – i’m an entrepreneur, i’m in the process of raising capital – help me by helping me avoid these ****s!

  • http://youarekillingme.net steveray

    Lets hope what goes around comes around with this firm.  Ten years ago this kind of thing was more prevalent.  The world is way too close for this kind of bullshit to be a good long term strategy.  Thanks for taking the time to post.

    Maybe in a month or two you can put a hidden tag on this post that the Google bots will see? :)

  • bbyrd

    Hey Seth, any chance you can share the language in the charter that the VCs used to define their way into a full liquidation?  

    It would be helpful to see precisely what language can be manipulated in this way.

  • btdt

    In 5 startups that I’ve helped start, what goes around… comes around. The investment community isn’t as large as some might think. 

  • http://www.justanentrrepreneur.com Philip Sugar

    One quick question first: Was the quote: “I have a fiduciary responsibility to my investors” used?

    Great post, let’s face it, there is a ton of asymmetry here.  Doesn’t downplay the point of the post at all its just the reason why its usually a one way street.

    Most of the time, the entrepreneur/company is ecstatic to get funded.  This isn’t the case if you are a super hot company, but most of the time at that point you have or are surrounded by people that have a ton of experience with VC’s.

    Same goes for VC’s most of the time you can pass on any deal you want and have twenty others begging for your attention.  Again, not in the white hot case where the company probably won’t let you do any DD.

    So most of the time the situation is the company can turn down its only current offer and the VC can turn down one of its twenty deals its looking at.  Total asymmetry.   No wonder it happens.

    It doesn’t make it right, and I’m sure everybody who has gotten screwed is looking to extract more than that value in return (its why having enemies, defined as somebody that takes pleasure in your pain is really bad).  I have extracted value like this in several situations, one where I kept getting the name of the reference mixed up saying how I loved somebody with the same first name but different last name until the reference finally got it.

    I think the attitude comes from the golden rule: “I have the gold I make the rules” not “do onto others as you would have them do to you”, because again all day long you have people begging you for money.

  • Royi G.

    What’s with the cowardliness? Name names – it’s like saying “don’t go to this restaurant!” without naming the restaurant. It’s pointless. How do we know who to avoid? Help us avoid the minefield and not let us hit those mines. If you are oblivious to the damage they’ll cause other startups they invest in, you’re just as much an asshole as these asshole VCs. Except you’re more self-righteous and cocky. We want names!

  • Joe@mama.com

    So…Brad Feld?

  • http://www.facebook.com/people/Susan-Perry/1550470339 Susan Perry

    I think we all have to thank Seth for a very thought provoking post and the fun graphic at the end. LOL.  Entrepreneurs have to stop being so desperate for a “marriage” that they don’t do diligence.  What they frequently forget is that without entrepreneurs there is no opportunity to invest.  In addition we all have a duty to talk and help each other along the path to doing better business.  It’s a scary and interesting world when you add VC’s to the mix.   

  • http://twitter.com/loud_noises Kyle Jeske

    well put.

  • Anonymous

    Seth, if the company had been domiciled in California, and under the jurisdiction of California law, could the majority of the Common, have blocked this? As I recall, a change in structure like this requires the approval of the majority of each class.

    I suppose the Assholes could still have held up the company by withholding their approval but at least it might have given the Common more power to negotiate.

    And with regard to naming names–I remember something we used to say when I was a journalist—eventually the bad guys get found out.

    Blogging, tweeting, and speaking with transparency—all stuff that’s exploded in the last ten years of VCdom—make that even more likely.

    Perhaps it’s obvious but still it’s worth stating that, when doing their diligence on potential investors, entrepreneurs should:
    a) call other entrepreneurs who’ve taken money from the investors
    b) call other investors–especially angels and common holders.

  • http://www.traackr.com Derek Skaletsky

    I have to agree with the comments pushing you to name names.  This is a really great post, but not helpful from an entrepreneur’s perspective.  The take away: “Don’t take money from Asshole VC’s” or “Do your diligence on your investors before taking their $$.”  But this story will never show up on any due diligence conducted on these particular assholes.  I’m incredibly interested in knowing what firm and what investors (specifically) pulled this BS…and just as interested in the law firm as well (whose behavior seems clearly illegal in this case).  Come on Seth…help us out.   

  • http://twitter.com/AndySack Andy Sack

    I enjoyed reading your advice and post.

    • http://www.sethlevine.com sethlevine

      Thanks Andy. Funny thing about this post – it had 300+ retweets and FB likes and a bunch of direct emails to me about it, but this is the first public comment. Not sure what to take from that, but thought it was interesting…

  • Anonymous

    Great post Seth. Your story strikes a cord as it wasn’t just about the investors. I’ve seen similar instances form “valley law firms” where they were supposed to be representing the company and backed the investors against the company because of their strong relationship with the VC’s. Benchmark was the investor. And Cooley was the law firm.

    • http://www.sethlevine.com sethlevine

      I really blame the law firm quite a bit here. They should have looked out for the company better…