Burned Angels: the Coming Wave of Minority Shareholder Oppression Claims in Venture Capital Start-up Companies

• Publication year: 2004

Jeffrey M. Leavitt⁰

I. Introduction

The venture capital industry has undergone dramatic and unprecedented change over the last decade. Relative to other areas of the economy, this may not seem especially material given the youth of the venture industry as a whole. The practice of venture capital investing as we know it today began only about sixty years ago,¹ and not without serious reservations.² Nevertheless, the recent growth figures are more than noteworthy. During the six-year period from 1997 to 2003 alone, the number of venture funds actively investing jumped from 885 funds managing $64.6 billion to 1,984 funds managing $251.4 billion.³ Nearly $200 billion of venture capital was raised in the year 2000 alone.⁴ In short, the venture capital industry has grown up.

The driver of this growth is plain. The technology bubble of the mid-1990s catapulted many venture capitalists, and the entrepreneurs they supported, into positions of great wealth. From 1997 to 2000, the mainstream media was saturated with tales of "new economy" risk-takers reaping millions overnight, to the disturbing envy of the "old economy" establishment. While the lucky few inflated their bank accounts, the jealous many inflated their dreams into unrealistic ambitions. Thus was the context for the venture capital industry expansion and the birth of the modern day angel investor.

While the concept of "angel" investing has existed for literally centuries,⁵ its emergence as a colloquial term and popular pastime for wealthy individuals is a recent phenomenon. With some variation, an angel investor is an individual investor considered "accredited" by the federal securities laws, who has disposable investment capital available for alternative asset class investment, and chooses to invest in early-stage technology companies. The divine nomenclature stems from the context in which a typical angel investment is made—namely, at the nascent stages of a company's life when only the most beneficent investor would consider providing investment capital. This first financing round is sometimes called the "friends and family round," since many angel investors have pre-existing relationships with the entrepreneurs in whose companies they invest.⁶

Angels generally invest with the expectation that, should the company progress as planned, one or more venture capital ("VC") firms will subsequently invest in the company's first "institutional round" of financing. Ideally, this second financing round will involve the sale of company stock at a higher valuation than at the angel round, resulting in some but not dramatic dilution of the angel's equity holdings. This process of selling stock to venture investors continues through the company's life until the investors realize an "exit opportunity," which is a financing event after which investors may liquidate their holdings. The potential reward gained from such an exit event, anticipated to be at a valuation much higher than the angel's initial investment, must be sufficiently high to justify the substantial risk taken during the angel round.

The angel investor community has grown alongside and beneath its venture capital counterpart, serving the significant role of supporting new companies from the point of conception through to institutional legitimacy.⁷ Angels have become more prominent and accessible over time, and are now common shareholders in the typical venture capital portfolio company. Many have banded together to create branded regional organizations focusing on sharing deal flow,⁸ utilizing communal resources such as lawyers and accountants, and providing capital for new venture capital-backed start-up companies ("start-up companies") in their home region.⁹ Moreover, the very definition of an angel investor has changed in relation to its larger venture capital cousin. While typical venture capital funds have grown in size to $200 million or higher, smaller venture capital firms, generally with funds of $50 million or less, are now sometimes referred to as "angel funds," since their small size and investment style is more akin to "nascent stage" angel investing than "early stage" venture investing. This article refers to both wealthy individuals and these smaller venture funds as "angel investors," since both are subject to the risk of minority shareholder oppression.

In theory, the role of the angel investor is magnanimous, exciting, and, in some cases, even heroic.¹⁰ Many active angel investors consider themselves to be the driving force of America's innovation engine, flush with patriotic pride as they wire funds to fledgling start-ups. The justification for angel investing also rests upon an attractive risk/reward model. As the argument goes, since angel investors take the most risk of any investors during the life of a new company, they stand to reap the greatest reward. While this may have been true in the past, the realities of venture capital investment practice have in many ways turned this theory on its head.

Venture capitalists are sophisticated financial investors charged with the sober responsibility of investing their funds' capital (usually supplied by pension funds or other non-trivial sources) in very risky early stage companies. Since many of the investments in a given VC's portfolio fail, the VC must be in a position to squeeze the most return out of those few companies that are successful. Consequently, VCs will often seek to structure the terms of investments so as to maximize their control of, and thus reward from, their portfolio companies. The specifics of these terms are well documented in other commentaries and beyond the scope of this article. What is important here is the resulting control of the company by the VC (or group of VCs acting in tandem by explicit cooperation or implicit alignment of interest), achieved either by owning a majority of the company's voting stock (or holding veto rights over certain actions and decisions of the company), controlling a majority of the company's board of directors, or both. Control of the company in this manner often appears fair and reasonable at the time of the VC's initial investment when each of the company's founders, angel investors, and VC investors are aligned in interest to grow their exciting new venture. The problems arise when things do not go as planned, and the interests of these three shareholder constituencies diverge. In such event, burdened by duties to maximize returns to a demanding limited partner investor base, the VC will invoke its control of the company to further its distinct interests at the expense of the angel investor.¹¹

The potential for abuse is high, as many "burned angels" have learned, while the means for legal redress have not yet been properly tested in court. Recent market trends, however, are increasing the likelihood that we will see such a test sooner rather than later. The unusual investment dynamics from 2001 through 2004, which brought about many highly dilutive "down rounds,"¹² have set the stage for legal claims that aggrieved angels may assert in coming years. In the heydays of 1999 and 2000, angel investments in start-up companies were quickly followed by venture capital investment. When the bubble popped, however, many of these companies watched their cash reserves diminish in the face of a tight-fisted investment climate. Raising new capital became extremely difficult, often forcing companies to raise additional funds from their current investor base.¹³ The VCs, with larger holdings and deeper pockets than their fellow angel investors, often ended up effectively dictating the terms of these "insider" rounds, in many cases without legitimate arms-length negotiation since they also controlled or at least substantially influenced the companies in which they were investing. Consequential negative effects on angel investor holdings were typical.

As we move through the improving capital markets of 2005, some of those same companies that struggled through insider or down rounds are improving their performance, growing well, and now have a reasonable chance of achieving a profitable return. If and when this happens, angel investors will be able to quantify their losses and, in appropriate cases, justify initiating litigation.¹⁴ While some cases of this ilk have been launched, none have survived pre-trial settlement,¹⁵ and theories of liability postulated by commentators are, accordingly, still only theories.

This article analyzes the claims angel investors might bring against VCs who took companies through insider rounds with "abusive" terms. Part II introduces the concept of close corporation law, well-established in American jurisprudence, and concludes that venture-backed start-up companies would likely be treated as close corporations in the eyes of the courts. Part III then presents what has become known as the close corporation "minority oppression doctrine," outlining a set of principles courts have established to protect minority shareholders in close corporations from the potential abuses of a controlling shareholder group, such as that comprised of VC investors. Particular attention is given to jurisdictions likely to address venture capital shareholder issues first, namely Massachusetts, California, New York, and, of course, Delaware. Part IV describes in more detail the role angels play as investors in nascent and early-stage companies, their motivations and expectations when making their investments, and the specific areas where risk of abuse against them is high. A listing of distinctions between an angel's interests and those of the company's founders and venture investors is also provided to highlight how and when the angel's unique interests can be subordinated to those of the company's other, more influential shareholder constituents. Part V applies the minority oppression doctrine to the plight of angels in venture-backed start-up companies, concluding that courts will...