Excerpt from the Growth Company Guide 4.0
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Real World Conflicts in Fundraising

If you think ethics are an abstract concept for venture financings, consider this real world example of a start-up biotech company’s experience with a prominent venture capital firm. In the world of early stage financings, roles and expectations can take surprising turns. In this case, everyone lost and a promising inventor saw his hopes of building a business dashed by an investor unwilling to meet its contractual obligations.

After considerable effort, an aspiring inventor sold his plan to expand his fledgling research business to a leading venture capital firm. The proposal was for $4 million in equity financing to be paid at closing contingent only on the inventor finding a business manager acceptable to the investor. The inventor had already plowed years of effort and invested substantial amounts of money to get his company operating and to acquire key patent rights from a university.

Within weeks the investor and the inventor settled on an individual identified by the investor to fill the role of business manager. As part of the deal, the business manager was to receive options to purchase up to 10% of the company that vested over a four-year period. Because this was a ‘friendly’ deal and because the lawyer the company had used also happened to be the lawyer for the venture capitalist, the inventor and his new found business manager partner chose to forgo engaging separate counsel to help them review the paperwork. For the $4 million investment, the investor was to receive 51% of the company’s stock and the right to elect two of the company’s three directors. The inventor was to fill the other spot on the board.

Troubles started when the inventor arrived at the closing. The investor, who was purchasing a Series A convertible preferred stock, had decided at the last minute not to invest the total $4 million at closing. Instead, he agreed to fund $2 million at closing and an additional $2 million in one year. Without viable alternatives, the inventor acquiesced. Twelve months later when the second $2 million came due, the investor had cooled to the company and refused to provide the additional funding. Without the funds the company would collapse.

Notwithstanding the investor’s clear obligation to provide funding, the company’s options were limited. Cash was tight and the company had no alternative investors. With the existing investor unwilling to provide the funding he was contractually obligated to provide, the company had little prospect of attracting a new investor.

Suing the investor to force funding was problematic. A lawsuit would be expensive and time consuming. Even a favorable result would come too late to save the company from financial ruin. Not only that, the investor promised to use its majority position on the board and as a shareholder to liquidate the company if it the investor forced it to put in the second $2 million, pointing out that it’s preferred security would entitle it to take the $2 million back in a liquidation before the inventor saw a penny.

Was this a violation by the investor of its contractual obligations? Absolutely. But the investor had more on his mind than just questions about his duties to his portfolio company. He was also concerned about his duties to his investors to minimize losses when he could and he was convinced that further investment in the company would result in increased losses. The investment, he now believed, was a mistake and he was willing to take some risk to avoid throwing new money into a bad situation.

The inventor contributed to his own woes as well. His naivety allowed him to close the investment without advice of counsel and he had engaged investor counsel to be his lawyer after the closing. As a result, he missed fundamental issues in his financing agreements that exacerbated his situation. For example, when he accepted half of the money originally promised, he should have insisted that the investor take half of the stock originally promised and reduce his board representation until the rest of the money was received. He could have also negotiated for a penalty in the event the investor later reneged.

Also, using the investor’s counsel for his lawyer may have contributed to his demise. Owing duties to both parties may have prevented counsel from proactively advising the inventor about the risks inherent in his deal structure. When the issue surfaced, counsel resigned the company account but continued to represent the investor, further complicating matters for the company and the investor.

What was the biggest mistake? Clearly the most costly mistake was the inventor’s failure, in the excitement of finding a investor, to investigate the investor’s reputation with other entrepreneurs. Had he done so, he might have avoided the situation entirely.

And, how did it end? Not as badly as it could have for the inventor. He learned from his mistake and engaged qualified counsel to advise him. After much discussion, the investor, probably on advice of counsel and in order to avoid publicity and exposure to liability, agreed to sell the inventor all of the investor’s stock in the company for $1 plus a waiver of the inventor’s rights as a significant shareholder to sue the investor for failing to provide the funding.