For Some New Companies, the Last to Invest Shall Be First by Ann Grimes, The Wall Street Journal, December 2, 2003, Pg. C1

As the fortunes of entrepreneurs and their early investors went south over the past three years, many who were desperate for new cash had little choice but to settle for draconian deals, or see their company and investment fail.

So now that the economy is perking up a bit, you'd think the worst was behind Silicon Valley.

Not so fast

As it turns out, those draconian deals in many cases left behind boards of directors at the young companies that have interests so conflicting that some now are hurting entrepreneurs, employees and early investors, according to two new reports that take the venture-capital industry to task for lapses in good corporate governance.

The reports focus on how venture capitalists who were last to invest in the companies found themselves in increasingly powerful positions, often able to wrest board control. Many were able to guarantee themselves a return on their investment at the expense of early investors, company founders, or employees who were either washed out or left with significantly reduced equity stakes.

The potential problem: When they sit on boards of companies in which their firms have investments, venture capitalists have a fiduciary duty to both the company and to the limited partners who invest in their funds, experts say.

For a venture capitalist which a significant investment, "there is a tremendous pressure to act to protect your own interests, which may be at odds with the interests of [the company's] shareholders," says Tracy Lefteroff, global managing partner or private equity and venture capital at accounting firm PricewaterhouseCoopers. He contributed to a report by Pascal N. Levensohn, a founder and managing director of San Francisco-based Levensohn Venture Partners, titled After the Term Sheet: How venture Boards Influence the Success or Failure of Technology Comapnies.

Mr. Levensohn, who cowrote the report with corporate-governance expert Dennis T. Jaffee, says the misalignment of interests has evolved into a "major problem" in Silicon Valley. When early and later investors have different financial concerns that don't align, they must resolve "difficult competing agendas" that can either deadlock or severely compromise the company;'s future, the report says. Such "financial engineering" is no way to build a company, contributors to the report say.

Mr. Levensohn's analysis, plus another recent survey issued by Alternative Investor's VentureOne, an industry research firm based in San Francisco, indicates that the situation is more commonplace than many venture capitalists allow. Indeed, at a time when many in the industry say the worst is behind them, the VentureOne study shows that, in 2002, and through the first four months of 2003, so-called down-rounds -- investments with harsh terms that lower the previous value placed on a company -- continued at a significant pace.

The VentureOne "Deal Terms Report" found that 42% of respondents saw their company's valuation decline in the most recent financing from the prior round, on par with 41% reporting up-rounds. Companies raising a third or later financing were hit hardest, with over 50% experiencing a down-round. Those deals often came with onerous, preferential terms that gave the most-recent investors priority over earlier investors, or antidilution clauses guaranteeing investors a return of their capital at the expense of founders and employees.

What's more, the study found, while venture capitalists typically shared seats on the boards of companies with founders and outside directors in the early life of a company, with the third and later rounds, investor-controlled boards "where the rule." This was especially true for information-technology companies, the study found.

The upshot is finger-pointing, stalemates and lawsuits.

One example, for instance, is disgruntled Silicon Valley entrepreneur Aamer Latif, who recently took out a full-page advertisement in the San Jose Mercury New, which also wrote about his experience. The ad featured the front page of a legal complaint he filed in Santa Clara Country Superior Count on Oct. 10 and directions to a Web site -- dubbed -- on which he posted the complaint against the venture backers of a company he co-founded, Nishan Systems Inc.

Among his allegations: breach of fiduciary duty by a board of venture insiders who topped off three funding rounds with a late-stage bridge loan prior to the company's sale. That financing ensured them a larger return at the expense of employees, he maintains. The venture capitalists involved call the allegations "baseless." They say they acted ethically, legally and in the best interests of a struggling company and common shareholders, many of whom made money and kept their jobs.

Similar scenarios can be "multiplied over thousands of companies.", Mr. Levensohn says, especially among the generation of companies that raised too much money during the boom, when valuations were high.

Preferential stock and dilution preferences are hardly illegal, he and other industry experts are quick to point out. "It's the norm to have different classes of stock, and generally investors only have the rights they bargained for contractually," says Michael C. Doran, an attorney with Carr & Farrell LLP, in Palo Alto, Calif. "The reason people have different classes of stock is because they made different contributions to the company at different phases in the cycle. Different contributions are valued differently."

But he adds, if preferred stockholders have preferences valued at $30 million when the company sells for only $10 million, "it can get ugly."

In some cases, it is venture capitalists who are left holding the short end of the stick. In one closely watched court case, in April a Delaware Supreme Count ruled against Benchmark Capital in a suit the Menlo Park, Calif., firm had filed against online financial-services venture Juniper Financial Corp., in which it had a $25 million investment. Benchmark's share was diluted by 75% in a later round of financing by investors that included Canadian Imperial Bank of Commerce, which invested in the company through its U.S. subsidiary.

A Benchmark spokeswoman says the firm negotiated contractual protections against such dilution, but CIBC and Juniper were able to structure a transaction that circumvented those protections. The count reasoned that the investment was entered into by sophisticated parties who failed to obtain the protections needed.

From a corporate-governance point of view, PricewatherhouseCoopers' Mr. Lefteroff says, "There has to be a mechanism in place to ensure protection, most likely relying on independent , outside directors." Under new corporate-governance requirements mandated by last year's sweeping Sarbanes-Oxley securities-reform legislation, companies intending to go public must have boards with independent directors.

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