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How Lawsuits Can Sink Your IPO Ambitions

Planning on going public? An ongoing lawsuit can ruin your chances.
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Ongoing lawsuits are bad for public companies--look no further than the sexual misconduct litigation Dov Charney has prompted over at American Apparel, or the investor suit against Lululemon for its malfunctioning yoga pants. That suit was dismissed this spring, but former chief executive Christine Day departed in its wake last year.

But what about small companies? While a certain amount of legal proceedings are probably par for the course for any business, ongoing litigation can be really damaging to longterm investor interest too. And today, when litigation related to noncompete agreements and from so-called patent trolls are on the rise, an excess of court proceedings may have already damaged public offerings and other longer-term prospects. 

"The compliance bar for companies to go public is much higher than in previous years, so things like pending litigation and accounting irregularities need to be clean," says David Zilberman, partner at venture capital firm Comcast Ventures. In short, lingering litigation can make it tougher for your business to garner the investment dollars you neeed to succeed, according to Zilberman and other industry experts.

It's probably no coincidence that some of 2014's most promising startups, which have backed away from the public markets, are also fighting ongoing court proceedings.

In 2013, for example, New York State Attorney General Eric Schneiderman subpoenaed the records of a quarter of a million people who rented out space through Airbnb. The apartment and house sharing company initially fought divulging those records,  but recently came to an informatoin sharing agreement with the Atronrey General's office, which is continuing to look into the company's business practices. The ongoing legal problems are, no doubt, a drag on the company, which has so far been quiet about any potential plans to go public.

Similarly, Uber and its competitor Lyft are embroiled in multiple lawsuits questioning whether they effectively operate as illegal taxi services in some cities. And a recent legal challenge in Texas claims that the ride services are not equipped to deal with handicapped customers, and as a consequence they discriminate against such customers.

While the ongoing legal disputes highlight the regulatory scrapes that so many sharing companies have undergone, storage and file-sharing concern Box also went quiet on its March plans for an IPO. The same week it filed to go public, a company called OpenText, filed a suit against Box, seeking $270 million in damages and an injunction against its products. (The injunction was denied by a district court judge in April, but the case is proceeding, and reportedly has over 200 claims pertaining to a dozen patents.)

Box indicated in a statement to the Wall Street Journal in May that it would go public when it makes "the most sense for the market."

The litigation hasn't stoped either Uber or Box from heading to venture capital investors for more money, which in turn has pushed their company valuations even higher. 

In June, Uber closed more than $1 billion from a number of venture capital companies, led by Fidelity Investments, making it the priciest startup ever with a value or more than $18 billion. Similarly, Box, which is led by Aaron Levie, Inc. magazine's 2014 Entrepreneur of the Year--is about to close a new round of venture capital funding. That infusion would value the company at approximiately $1.2 billion.

But the litigation hasn't helped either.

"These days, private companies are highly scrutinized by the SEC and prospective public market investors prior to listing an initial public offering," Zilberman says. Much of the increased scrutiny is the result of the corporate malfeasance scandals of the early 2000s, with which the now-defunct energy company Enron and telecommunication company Worldcom have become synonymous. Those scandals, in turn, prompted the Sarbanes-Oxley Act of 2002, with its added compliance measures for public or soon-to-be public companies.

A recent study from MIT's Sloan School shows the negative impact that ongoing litigation can have. Between 2004 and 2012, it found between $4 billion and $19 billion in direct costs to businesses associated with patent litigation. Further, the study found that venture capital investment might have been $8 billion higher over the same time period, except for the litigation brought by frequent litigators. That number shoots up to $109 million over the same period, except for infrequent litigators. 

Extended litigation can also be a terrible distraction from business, which is worrisome to investors. Says Ross Fubini, partner at Canaan Partners, a venture capital firm in San Francisco:

"Many companies deal successfully with litigation in their lifetime, my concern would be the distraction from the core business."

IMAGE: Getty Images
Last updated: Jul 7, 2014

JEREMY QUITTNER | Staff Writer | Staff Writer, Inc. and Inc.com

Jeremy Quittner is a staff writer for Inc. magazine and Inc.com. He previously covered technology for American Banker and entrepreneurship for BusinessWeek.




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