Suing Your VCs: Rapt vs. Accel & Levensohn

Matt Marshal of VentureBeat and Dan Primack of PE Week have written interesting posts on two co-founders of Rapt, a once promising Silicon Valley startup, who are suing the company's CEO and its investors, Accel & Levensohn. (UPDATE: Matt Mcall Also wrote a very good post on these issues) I believe that Rapt's law suit is an important case-study because it is so hard for entrepreneurs to get an accurate picture of how VCs react when it all goes wrong. How does an entrepreneur perform due-diligence on their prospective investors when VCs wipe all evidence of any of their failures from their websites? I want to write a little bit more on why I believe the conspiracy theories of evil VCs colluding against entrepreneurs are overblown below, but first here are a couple of quick thoughts on the Rapt law suit.

First let me be clear that I have no insight into the details of the the situation at Rapt other than what I've recently read in the blogsphere. Furthermore, I've never met any of the parties involved, other than occasionally reading Pascal Levensohn's blog and hearing him speak a couple of times. However, I am certain that that there are three sure-fire ways that entrepreneurs will windup taking heavy dilution:

1. Leaving the company
2. Lack of success leading to down rounds
3. Exacerbating 1 & 2 by not getting along with other team members and/or investors
   

Rapt went through two down rounds, the co-founding plaintiffs both left the company and (according to Mr. Primack's article) one of them had numerous runins with the CEO... Given these factors, its hard for me to imagine the co-founders holding much stock even in the best of circumstances.

The co-founders claim that the second down round was not necessary and done specifically to wipe them out because they left. This would certainly be nasty and unethical behavior if their is any truth to the accusation. However, the good news is that it should be relatively easy to investigate because reviewing Rapt's financial records and the minutes of their board meetings will demonstrate whether they were running out of cash and/or needed an influx to pursue a new opportunity.

A serious concern definitely exists amongst entrepreneurs that venture capitalists will ultimately try to take over, fire and/or wash them out, but I've always felt this was overblown. VCs only goal when they invest in a company is to make money and there are some nasty characters in the VC industry but Silicon Valley startup community is a very small place and I don't think many people can sustain success by screwing entrepreneurs.

I heard Pascal Levensohn say that the empirical evidence demonstrates that startups where founders are not replaced are significantly more likely to succeed than situations where they are replaced, at a talk he moderated earlier this year. Founders are rarely replaced when startups are successful, so I think this somewhat misleading data. However, rock star CEOs with liquidity events under their belts are the most sought after component of any startup and VCs clamor to fund them. It is also worth noting that while venture capitalists want maximize their returns, those returns are dependent on the performance of the startup. Thus, gouging management doesn't make sense because it has a direct impact on incentives and motivation to succeed. Furthermore, Venture capital is a relationships business and screwing entrepreneurs is short sighted.

That said, being screwed and feeling screwed are two different things. My subjective pool of personal relationships, acquaintances and experiences tells me that many entrepreneurs have unrealistic expectations that aren't grounded by market realities and some do not even fully understand the terms and preferences they are agreeing to when they raise capital. Moreover, unsuccessful companies have turnover and founders should be no more immune than any other non-performing team member. Its a heartbreaking and gut wrentching experience for founder to fired and this emotion often obscures objectivity... Does getting rid of a productive team member ever really make sense for anyone involved?

Entrepreneurs that want to control their companies need be successful and David Cowan's post on startup boards really says it best:

"I have learned from experience on 40+ boards that they don't matter. Real control has nothing to do with the documents, and everything to do with the color of the ink at the bottom of the cash flow statement. Simply put, when a private company is losing money, the investors control it, and when it's profitable, control rests in the CEO's hands--unresolvable differences between the CEO and investor group inevitably pan out this way. It's simply a matter of which is more dispensible at the time--the financial support of the venture firms, or the knowledge and momentum that the executive team brings to operations."

If a company isn't successful and needs cash, it is going to have to give up control and ownership to get cash. Furthermore, the market currently supports liquidity preferences, which ensure that VCs will always going to get their cash out first. Thus, a moderate hurdle exists before entrepreneurs can make money under any circumstances. The best way for entrepreneurs to avoid getting screwed is do their due-diligence on prospective investors in order to ensure they aren't working with one of the few bad apples and to understand the current market liquidity preferences. Ultimately, success is only way to maintain control of a startup and losing control, getting crammed or being fired really aren't unreasonable outcomes if it all goes wrong.