October 17, 2002 SOMETHING VENTURED: Clawbacks Loom As The Next Indignity By Mark Boslet, of Dow Jones Newswires PALO ALTO, Calif. -- Venture capitalists have had little to smile about in the past two years. Investment returns have tumbled, portfolio companies are struggling and job security for many general partners is decidedly more tenuous. Now there's a new indignity facing the industry: "clawbacks" - contractual obligations that could force partners to write personal checks to investors who have lost money in a venture fund. This latest twist of fate could pit general partner against general partner and touch off the liquidation of beach houses, late-model Porsche Carreras and already pummeled stock holdings. "It's going to hit the firms that did well early on (during the dot-com bubble) and aren't doing well now," said Gary Benton, a Silicon Valley attorney at Coudert Brothers LLP. Only a few top-tier firms have the clout to keep clawbacks out of their fund-raising agreements. For most of the industry - an estimated 80% to 95% of the partnership pacts have clawbacks - they are unavoidable financial safeguards that ensure investors get back their principal before VCs can keep any of a fund's profits. After the repayment of principal, profits typically are split 80-20, with 80% going to the investors. Three years ago, few in the volatile world of private investing thought about clawbacks. Times were good, profits were flowing and the market's upward spiral appeared to have no end in sight. Venture firms made big bucks taking the latest dot-com startups public and, in many cases, held onto some of the cash believing more would follow to repay investors. Now these same funds are fighting for their lives, and portfolios look unlikely to return enough money to make their final payments to their limited partners. "A number of funds are living with the potential" of paying clawbacks to cover the obligations, said Bob Roeper, managing director of the VC firm Venture Investment Management Company LLC. The fear of financial liability is stirring up a lot of talk among general partners and pushing firms to action. "What we are seeing is some of the (general partners) reducing their management fees now in exchange for reducing the size of their clawbacks" in the future, said Chip Lion, an attorney at Morrison & Foerster LLP. "You are seeing pressure on these funds that have potential clawback liability to manage that liability." Other firms have begun exploring alternatives: cutting partner salaries or promising a greater profit payouts to investors on future funds. Some insist their portfolios will rebound over the average 10-year life of a fund, eliminating the problem. Perhaps the most foresight has been shown by partners at TA Associates, who dug into their pockets to write checks of an average of $2.4 million apiece. TA Associates in August turned over about $38 million to investors. The firm "wanted to get out in front of this thing," said C. Kevin Landry, its chief executive. It also tried to keep its decision quiet. "We didn't want to grandstand and make a big announcement and put a lot of pressure on other people." The payments were tied to several TA funds from the mid to late 1990s that in large part did well. Profits paid to partners early on were simply too large, Landry said. TA continues to evaluate the clawback liability based on quarterly changes in market conditions and vows to write additional checks if necessary. That is the "gold standard" for how to deal with clawbacks, said Katie Stokel, managing director at investors Abbott Capital Management LLC. Stokel said she has discussed clawback liabilities with other VC firms, some of which are considering fee reductions. So far, "it's been fairly well (and) professionally handled," she said. But there is no guarantee the gentlemanly demeanor will remain, especially as partners debate how to mete out who will pay. "There are going to be general partners five years from now who will have to write checks," said Mark Saul, a general partner at the VC firm Foundation Capital. It is hard to know how people will behave under the stress, he said. Some firms will probably turn to the courts to retrieve money from partners who have left and who resist a request for payment. Some clawback clauses contain such complicated language they may require the legal system to untangle them. Industry observers speculate as well that some partners may claim bankruptcy to protect assets such as homes and cars. Battles almost certainly will arise over clawbacks that can place the payment burden on one general partner when another has spent his money or lost it in the stock market, a recipe for resentment. "It's going to be very ugly," said Eric Hirsch, chief investment officer at Hamilton Lane Advisors. When it comes to the possibility of lawsuits being filed, "I have to believe the answer will be 'yes."' At greatest risk are funds raised in 1998, 1999 and 2000 that had profitable starts, but which fell on tough times when the stock market reversed itself. Some of these funds paid profits to limited partners as well as general partners deal-by-deal. When the first handful of deals came in with big gains, general partners pocketed some of the spoils. Since then, the remaining companies in the portfolio have fallen in value and the funds have been marked down. VCs who hope to remain in the business have plenty of incentive to settle up with investors over these changes in value. In a year or so, they will be knocking on these limited partners' doors to raise money for their next fund. "In the past six months, (the issue) has really heated up as a concern," said Coudert Brothers' Benton. "Everybody is going to have to take a look at how their portfolios are performing. They (also) need to talk to their lawyers and accountants now."