VCs Must Fend For Themselves, Experts Say

In the wake of mass layoffs at venerable private equity firms such as 3i Group PLC and GE Equity, and with more job cuts sure to come down the pike, it may be high time for venture capitalists to start evaluating what, besides their rolodexes, they can take with them when they walk out the door.

Leaving a private equity partnership can be a little like divorcing a wealthy spouse without first having signed a pre-nuptial agreement. When VCs sign on with a firm, the terms of what they may or may not be eligible for when they leave or are laid off are not always defined. That negligence can cause major headaches down the road when a VC and the firm part ways, private equity lawyers say.

The difficulty applies mostly to members of a general partnership, who have signed on either at the fund’s formation, or at a later date, and have a vested interest in the carry and management fees.

“When someone leaves the firm, you have to consider the dissolution of the partnership agreement and the vesting schedule,” explained Peter Blasier, a partner with Reed Smith LLP in Pittsburgh. “Circumstances change, so what you may have agreed to up front may not necessarily be applicable when you leave, and so there’s a lot of back and forth as to what’s fair and what makes sense.”

Some firms will draw up separation agreements, or will require an investment professional to sign a non-compete, non-solicitation agreement at the outset of his or her employment, that says, upon his or her departure, that he or she cannot poach employees or prospective deals from the firm within a given period of time.

Far too often, however, that isn’t the case, Blasier said.

“When companies hire a CEO, they have a well-drafted employment agreement with a non-compete built in,” he added. “It should be the same for private equity firms. The relationship between the partner’s equity position and the vesting schedule relative to that position should be clearly outlined when he leaves, for example.”

In a partnership, these concerns aren’t always addressed, however, perhaps because the negotiations surrounding their formations are so democratic, Blasier speculated.

“They’re thinking about raising that fund so they can go out and make investments right away,” he said.

Hence, at the outset, some of the more complex considerations of a distant separation may fall by the wayside.

Legal Logistics

Another issue that often goes unresolved is, who picks up the legal fees when a company sues a VC that once sat on the board of directors after he or she has already left a particular fund?

“People get sued, especially if the company goes public,” said Gordon Caplan, a partner with the law firm Mintz Levin Cohn Ferris Glovsky and Popeo in New York. “People [at these companies] are looking for deep pockets when the company blows up. If the individual sat on the board and made decisions good or bad – the company goes after them.”

The law suit is derived from actions the VC took while sitting on the board of a particular company, so he or she is ultimately responsible for the cost of the legal fees, Caplan said. If he or she is no longer a member of the general partnership, the fund often will not pay those fees, and indemnification from the plaintiff is only as much as the company is worth, which often isn’t much by the time the suit is over.

“What should get negotiated is that the indemnification the partnership provides should survive, but that usually gets ignored,” Caplan said.

Hence, the rise of the increasingly popular directors’ and officers’ insurance, commonly known as a “D&O” policy.

“Particularly when an investor gets involved in a company, if that company doesn’t have D&O insurance, the investor should get some,” Blasier said. “The amount of insurance may be subject to negotiation, but the reason for the insurance is that directors have a fiduciary duty to shareholders, and if there is a suit for a breech of that duty, an investor should have coverage [for the costs associated with] legal protection.”

The world of venture capital is becoming ever more complex, especially as returns lapse as a result of the economy’s downward pull and the investment pace slows to a crawl as the holiday season approaches. With no immediate upside in sight, and job cuts becoming the rule rather than the exception, VCs who suddenly find themselves out of a job need to keep their best interests in mind.

Robyn Kurdek can be contacted