Accel Partners and Levensohn Venture Partners have been sued by two entrepreneurs for fraud and breach of fiduciary duty, according to a complaint filed late last month in San Mateo Superior Court. The case likely will be settled out of court, but it serves as a cautionary tale for VC-backed company founders who move on before their venture backers have obtained liquidity.
The suit was filed by Adam Galper and Paul Dagum, two of three Sun Microsystems vets who started pricing software company Rapt Inc. in April 1998. The third co-founder, current Rapt CEO Tom Chavez, is named as a defendant alongside Accel, Levensohn, Rapt and individual investors Arthur Patterson (of Accel) and Kip Sheeline (Levensohn).
In past cases where founders have sued VCs, the litigation typically followed a company’s sale or IPO when there was money to be divvied up. In this case, there has been no exit event, but the plaintiffs claim in their suit that Rapt is in “strong financial shape.” The complaint says the company reported revenue in excess of $20 million in 2005, more than doubling its 2004 sales.
PE Week contacted Galper, Dagum, their attorneys, Accel’s Patterson and Jim Breyer and Levensohn’s Sheeline and Pascal Levensohn. None would comment for this story.
The two sides are scheduled to meet in a complex case status conference on Sept. 15, and a case management conference on Sept. 26.
In the suit, Galper and Dagum allege that their Rapt equity was unfairly diluted by the defendants, in part because they each had left the company to pursue other interests. They had received founder’s common stock while bootstrapping the company, although the suit does not specify how much. Rapt raised its first round of institutional funding in November 1998, with co-plaintiff Bristol Investment Co. providing notes that later would be converted into common stock. The issue of common stock soon became important, since subsequent investors would receive preferred shares.
Accel was the first such investor, leading a $4.7 million Series A preferred round in July 1999 at a pre-money valuation of $6 million. The tranched-out deal included Series A-1 stock offered at 44 cents per share and Series A-2 stock offered at 66 cents per share. Later, Summit Partners led a $27.8 million Series B preferred round in May 2000 at an $80 million pre-money valuation ($2.78 per share), with Sheeline, who was then a GP at Summit, taking a board seat.
During this period, Galper and Dagum contend that Chavez began treating them as “mere subordinates than partners.” Galper left his CTO role to take a similar job with XTime, while Dagum stayed aboard as chief science officer.
By the time the company raised a $9.13 million Series C in March 2002, the bubble had burst. Rapt’s funding was at a pre-money valuation of $32 million (83 cents per share). Levensohn led the deal, with new Levensohn partner Sheeline maintaining his seat. The company also raised a $5 million convertible bridge loan in January 2004 from existing preferred shareholders.
Dagum had had enough of Chavez and Rapt by May 2004, and said as much to both Chavez and Patterson. Their reply, according to the complaint, was that Dagum would be making a big mistake were he to leave. Not only would he forgo future equity, but they would be sure to severely dilute the value of his existing shares. According to the complaint: “Between June and September of 2004, Chavez confronted Dagum on several occasions in Dagum’s office at Rapt and, in a hostile tone, warned him that the Board had already decided to ‘smash’ his equity interests if he departed. Chavez told Dagum that there was nothing Dagum could do about it and that ‘that’s capitalism.’ Indeed, Chavez was very specific about how Dagum would be smashed down, mentioning a double-trigger accelerated vesting event for a recapitalization of Rapt, that would allow Defendants to get additional equity at the expense of departed employees.”
Dagum decided to leave anyway. The company completed a Series D financing earlier this year, at a pre-money valuation of about $35 million (13.2 cents per share). This represented a second straight down-round when the Series C capital is considered, and particularly diluted common shareholders. In addition to receiving Series D preferred stock, each participant received nine common shares for each outstanding share of Series A and Series B preferred stock, and 12 common shares for each outstanding Series C preferred share.
It is important to note, however, that not all common shareholders were affected equally. Rapt increased the current employee option pool by 10x, to “make them whole.” It also allegedly included a carveout for Chavez, so that this founder’s equity would not be similarly washed away. Neither Galper nor Dagum was offered any “make whole” provisions or a carveout, thus reducing their ownership interests by about 90 percent, according to the suit.
The complaint argues that the Series D round this year was a breach of fiduciary duty, because it had a disproportionately adverse impact on one group of stockholders as compared to the others. Moreover, it argues that the round valuation was artificially low (based on revenue growth), and that Accel and Levensohn did not adequately seek third-party funding.
The defendants have not yet filed a formal response. One possible defense, however, would be that the firms were in compliance with the law, based on the business judgment rule (i.e., the deal served a legitimate business purpose). This could be invalidated if Galper and Dagum could prove revenge as the primary motivator, but they have not yet presented any written documentation to that effect.
Moreover, Accel and Levensohn will certainly point out that Summit Partners opted not to exercise its pro rata rights in the Series D round. If an insider wasn’t even interested, what would make Galper and Dagum so sure an outsider would be?
Senior Writer Alexander Haislip contributed to this story.