Venture capitalists do more than write big checks to entrepreneurs. Sometimes, they go out of their way to defend their investments from rival startups.

Entrepreneurs beware: pitching your plan to the wrong venture capital firm could prove harmful to your startup's health.

The benevolent image of the venture capitalist as nurturing, well-connected financier masks a darker side that rarely shows itself in public: To protect their investments, VCs sometimes use their connections to make life harder on a competing startup. Even for those that take the high road, growing networks of investments and partnerships make it increasingly difficult to avoid conflicts.
Roy Tuvey learned that lesson firsthand. As founder and CEO of Mailround, a London-based company that folds advertisements into e-mail, Tuvey was sniffing around for venture financing while trying to stay below the radar of potential rivals. He shook hands on an investment with Chase Episode 1, a $100 million U.K. Internet-focused venture fund backed by Chase Capital Partners.

Quickly, news of Mailround's funding and a rough sketch of its future plans were shared with Flatiron Partners, a New York venture firm that's also affiliated with Chase Capital. Flatiron in turn shared the information with Expression Engines, which has plans to add ad banners to e-mail messages. And, according to Flatiron managing partner Fred Wilson, in an e-mail he inadvertently sent toThe Standard, Episode 1's investment in Mailround would be in jeopardy if Tuvey failed to join forces with Expression Engines. Flatiron and Chase both defend their actions, reporting that the investment in Mailround will go forward as planned. Both firms add that they always get permission before sharing details about potential investments with companies already in the portfolio. [Flatiron and Chase together led a $30 million round of financing for The Standard.]

In an interview, Tuvey appeared troubled to learn that Expression Engines even knew about Mailround's existence. "I'm very surprised that we've hit anybody's Richter scale," he said. "At this stage we're keeping exactly what we're doing very confidential." Tuvey declined to comment on the discussions about his company that occurred among Episode 1, Flatiron and Expression Engines.
The episode offers a rare glimpse into a practice many entrepreneurs grumble about privately but virtually none discuss publicly for fear of angering powerful venture capitalists. But a variety of VCs, corporate law attorneys and business ethics professors say they're uneasy with such behavior.

Wilson sent his e-mail to three board members at Expression Engines. The subject line included Mailround's name and the message said that it was "the name of the startup in the U.K. that Episode 1 is funding."

The e-mail continued: "Apparently Episode 1 tried to convince the entrepreneurs to license our technology and build a global company. But the entrepreneurs don't like our technology. They think that they can do it better, faster, cheaper. And they want to remain independent. I may be able to kill Episode 1's investment. We'll see."

Wilson concluded by saying thatMailround was bound to get funding from someone, so the directors should consider alternatives for Expression Engines to establish a foothold overseas.
Bill Davidow, a partner at Mohr, Davidow Ventures who has been in the VC business for more than 30 years, says that unless news of Mailround's existence and funding was common knowledge, Flatiron "should not have sent the e-mail."

Wilson said in an interview that he was trying to protect his $2.5 million investment in Expression Engines. "The only issue is, given Episode 1's relationship and Flatiron's relationship with Chase, does it make sense for two groups that are friendly to have investments in companies that are competitive with each other?" he said.

No one at Flatiron or Expression Engines has been privy to Mailround's business plan, Wilson stressed. "All we know is that the guys in the U.K. gave us a call and said, 'We're looking at [Mailround's] business plan and it's similar'" to that of Expression Engines.

Jeff Walker, managing partner at Chase Capital, says the firm won't discuss one company in the investment network with another without the consent of both. "It's a full disclosure process," he says. Officials from Episode 1 didn't respond to requests for comment. Venture firms with ever-growing tentacles are finding it increasingly difficult to avoid conflicts among their myriad investments. Chase's venture network has funneled more than $23 billion of capital into several hundred companies; Softbank and CMGI have invested even more. "When you have hundreds of companies in your portfolio it's incredibly hard to … know when a conflict exists," Davidow says.

Whether innocent in motivation or not, those kinds of conflicts serve as a reminder of just how few alternatives most entrepreneurs have when a venture capitalist appears to have stepped over the line. In the absence of a fiduciary relationship, "there isn't a great deal of protection, and entrepreneurs should know that," says Allen Ruby, a San Jose, Calif., plaintiff's attorney who has taken on VC firms in court.

Ruby says the best, and possibly only, way to protect a startup is to get the venture capitalist to sign a nondisclosure agreement, a contract few venture capitalists ever enter. With 200 or more business plans crossing his desk every week, Wilson says expecting him to sign a nondisclosure agreement "is an untenable position."

Other professions face similar conflicts, but unlike the world of venture capital, systems exist to keep them in check. Lawyers answer to bar associations, and medical doctors receive oversight from state regulators. In finance, investment bankers must reckon with the Securities and Exchange Commission and auditors to a self-regulated industry body. All attempt to ensure that minimum standards are followed.

Despite venture capital's growing influence, though, there are virtually no regulatory bodies, trade groups or even books to help guide a practitioner wrestling with an ethical dilemma. "The relationships that are beginning to be institutionalized have had their origins in a series of handshakes that have never had to face the sunlight," says Dennis Moberg, acting executive director of the Markkula Center for Applied Ethics at Santa Clara University. "There's very little that's been codified that lays out the issues and identifies the sticking points."

Wilson concedes that there are plenty of sticky issues for venture capitalists to sift through, noting that the predicament he faced with Mailround "happens all the time." He bristled at the notion that his profession should receive any sort of oversight – even self-imposed. Venture capitalists, he argues, are kept honest by their need to maintain a good reputation among a closed-knit group of entrepreneurs and fellow venture capitalists. For a prominent VC, reputation carries as much weight as regulation.

It isn't uncommon for a VC firm like Flatiron to invest in one company only to be presented with an opportunity to invest in a more appealing company in the same space a few weeks later. Invariably, Wilson says, the firm will turn down the second company: "We're not going to do anything that leads directly to a loss in our investment."

The assurance fails to satisfy some, especially now that venture capitalists are playing influential roles in the economy. "Because they are the drivers of this economy right now, they have even more responsibility to be a part of the ethical fabric of corporate America than they have demonstrated thus far," says Michael Hoffman, executive director of the Center for Business Ethics at Bentley College in Massachusetts.

Ashish Nanda, an assistant professor at Harvard Business School who specializes in business ethics, agrees. While believing regulation of venture capitalists is impractical, he favors establishing a body similar to the Better Business Bureau, where disgruntled businesses could register complaints. "Some sort of clearinghouse for entrepreneurs telling them about the reputation of different venture capitalists would be useful," Nanda says.

Entrepreneurs would do well to do their homework before pitching to anyone. A thorough screening includes looking not only at the particular venture firm being solicited, but also at any affiliate or parent firms. "Entrepreneurs need to recognize that there are connections across these different organizations," Wilson says. "They need to be sensitive to that, and we need to be sensitive to that."
 

Source:  Dan Goodin, The Standard, February 21, 2000