For good reason, the business of venture capital firms is focused largely on core business issues such as raising capital, product/market fit, and deal flow. However, as such firms guide and interact with their portfolio companies, litigation issues can result and become a pressing concern for such firms, especially with respect to applicable securities laws and attendant fiduciary obligations.
Our experience litigating in this industry has shown that venture capital firms are open to a wider range of potential liability than they might anticipate. This is increasingly true as they become important players in the day-to-day activities of their portfolio companies. This article will address some of these potential litigation pitfalls by considering liability for a venture firm in two common scenarios that can go overlooked: (1) a venture firm providing guidance and advice to portfolio companies regarding its vendor and supplier relationships; and (2) a venture firm providing expertise and assistance with a portfolio company’s product development.
Example #1: Facilitating Supplier Relationships
As a venture firm, one of the primary benefits you can offer a promising young company is your experience and expertise. For example, consider the scenario where your firm is approached by one of its portfolio companies asking for help to identify and develop new sources for critical components in its flagship hardware device. You give them the names of suppliers in your rolodex—handling the initial introductions and maybe even assigning your in-house engineers to help with a recommendation. On your advice, the company decides to cut ties with its old supplier and go into business with the one you recommended. While this seems like a harmless scenario, it is one that can lead to a lawsuit if you are not careful.
You may not have realized that the original supplier depends on your portfolio company as one of its key customers. Worse still, there may have been an exclusive supply agreement that you knew nothing about. Once the supplier discovers your role in eliminating its critical source of revenue, they could become desperate and consider naming the portfolio company, your fund (including the general partner and management company), and even your board representatives in a lawsuit.
But is it really against the law to simply recommend a new supplier to your portfolio company? The short answer is that it depends on the facts. The longer answer is that it may not matter if you were right or wrong, because lawsuits are expensive and they can impact many other aspects of your business.
Essentially every US state has laws on the books that allow a business to sue a third party (i.e., the fund and its affiliates) which has intentionally interfered with its contracts and/or its business relationships. The specific cause of action is referred to as “tortious interference.” Where a contract exists, California law requires a prospective plaintiff to demonstrate six elements to impose liability:
- A contract existed between the plaintiff and a third party;
- The third party knew about the contract;
- The third party engaged in conduct that prevented or hindered performance of the contract;
- The third party intended to disrupt performance of a contract, or knew disruption was certain or substantially likely to occur;
- This harmed the plaintiff; and
- The third party’s conduct substantially caused the plaintiff’s harm.
However, California (and several other states) may also impose liability even where there is not a contract. Absent a contract, a prospective plaintiff must demonstrate that the third party knew of the supply relationship, but engaged in conduct that it knew, or should have reasonably known, would disrupt the relationship. These facts often require considerable discovery to adjudicate.
We have had success litigating these cases, particularly where the third party defendant is able to show that it had no reason to know about the specifics of the original supplier relationship, or where the supplier had no reasonable expectation of continued business relations with the company at issue. But even a successful defense can be cold comfort when the litigation takes years to resolve at considerable expense to the defendant.
Example #2: Sensitive Business Information & Close Working Relationships
Consider another scenario where your firm has been asked to provide substantive technical assistance to one of your portfolio companies, for example regarding an ongoing problem with the company’s source code. Working together, one of your in-house software engineers helps the company to successfully address the problem, and the product goes live a few months later.
As it turns out, the founders of your portfolio company previously worked at an established competitor in its niche industry. The founders may have taken sensitive business information with them, including certain aspects of their current source code. When the competitor finds out several months down the road, both your portfolio company and your firm are sued for trade secret misappropriation.
The elements for trade secret misappropriation claims can vary from state to state, and from the federal Defend Trade Secrets Act. In general, a trade secret is information that has independent economic value because it is not known to the public, and the trade secret holder works to keep the information private. That may include a program, formula, or other process.
In this hypothetical, the plaintiff must prove to the court that certain aspects of your portfolio company’s source code were acquired by another through improper means, and that both the company and the venture firm had reason to know this was the case. In California, a prospective plaintiff must be able to show:
- The plaintiff owns information that qualifies as a trade secret;
- The information was a trade secret when it was allegedly disclosed or otherwise taken;
- The defendants wrongfully acquired, used, or disclosed the trade secret;
- The plaintiff was harmed by that conduct or the defendants benefitted from it; and
- The defendants’ conduct was a substantial reason why they benefitted from their conduct, or why the plaintiff was harmed.
You might be surprised to learn that your involvement in addressing your portfolio company’s source code issues could expose you to litigation. And in most cases, you will have valid defenses—such as a lack of knowledge that the source code wrongfully incorporated the competitor’s business secrets. Regardless, these cases can be difficult to get dismissed during the early stages—particularly where the competitor can show that you had some involvement in working with the source code. The plaintiff is also likely to seek a preliminary injunction which can lead to expensive and disruptive litigation with very little lead time. Moreover, trade secret misappropriation cases can be particularly harmful to your firm’s reputation.
As venture firms look to distinguish themselves from their competitors, the breadth of their involvement in the day-to-day challenges of their portfolio companies is likely to increase. Our discussion here is by no means exhaustive, as venture firms routinely insert themselves into portfolio company issues such as hiring and firing decisions, marketing strategy, and various technical challenges, all of which can bring with them the potential for further litigation exposure. Moreover, your firm likely has deeper pockets than your portfolio companies, making you a prime target in litigation.
In our experience, it is best to consult with litigation counsel before undertaking the kinds of activities that lead to litigation. Each circumstance carries its own unique set of liability risks, but you can mitigate those risks by working with counsel to spot issues, document your activities, and avoid obvious pitfalls.