Monday, May 25, 2009

Rule Book for Tough Times: Who Employs You - Your Company or Your VC?

Here’s a story I’ve heard before, both in the last down turn in the early 2000s and today: Start-up Company X is going through a cash crunch. Its backers, VC 1 and 2, approach the CEO and tell him his time is up. However, they advise, they won’t pay him out the full amount of severance he negotiated in his employment contract. The Company doesn’t have the cash, they say, and they’ll bridge the Company with additional funds if and only if the CEO agrees to a lesser payout. The CEO, feeling he has little choice, takes the deal.

Not so fast.

Any investor who tries this out on you is relying on the belief that, as an investor, he’s immune from liability for your severance package. But is this the case? Can VCs/angels who step in like this and control portfolio company operations find themselves liable?

This issue has been lurking over North American venture capital for years. In the US, lawsuits have been brought typically based on the "single enterprise" theory, that when a VC makes executive decisions or takes other controlling action, two different entities, it and its portfolio company are deemed to the same legal entity.

In Canada, a similar theory about the liability of controlling shareholders has been advanced. There are also a number of Statements of Claim that have tied this kind of behaviour to liability for oppressive conduct.

To my knowledge there is still no precedent-setting case on the issue north or south of the border. This is largely because most VCs appear to have settled once litigation was launched.

There is a tendency for VCs (and angels, for that matter) to take over the reins of portfolio companies businesses in troubled times. Unless they do so in a way that keeps them separate themselves from their portfolio companies, they invite exposure. There are a number of factors to assess when determining whether VCs (or angels) have crossed the line into liability, but I’m not going to enumerate them here. You want to know, you can always call me and ply me with flowers. But don’t let your own position (or your company’s ability to continue to restructure with a bridge) be compromised because of overly enthusiastic investors.

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