Why a haphazardly made venture capital deal may cost a successful entrepreneur her company.
Back in the early days of Discovery Toys, founder Lane Nemeth accepted $100,000 from Phil Greer's VC firm. Ten years later the deal may cost her the company
The adversaries in these events would tell you this is a story about dishonesty, or the clash of a company builder's vision with an investor's self-interest, or the principle of fairness. But it isn't. It's about money. And, like all stories about money, it's about greed.
More particularly, it's about what can happen when one small deal is haphazardly made. In this case, the result was a fight that will determine the future of hugely successful Discovery Toys Inc. And if the fight's outcome is still unclear, the stakes are not. Though Lane Nemeth founded it, runs it, and with her husband owns more than two-thirds of its privately held stock, she may lose her company.
When you talk to Nemeth these days you get the impression that this potential consequence hasn't yet sunk in -- that it strikes her as all too, well, inconceivable to actually happen. It's easy to see why.
Having started Discovery 12 years ago with a $5,000 loan from her family and a love for quality toys, Nemeth now finds herself with a profitable, $70-million direct-sales toy company -- all without the benefit of a background in business. From humble beginnings in her garage -- her then-baby daughter, Tara, crawling among the boxes -- Nemeth built Discovery into one of the nation's top-grossing companies of its kind, joining an elite group that includes Avon, Tupperware, Mary Kay, and World Book. In the process the 43-year-old Nemeth has become a touted female entrepreneur and working mother, the subject of countless inspirational tales about having it all.
But next month Nemeth's tale could be about losing it all instead. On August 20, she's scheduled to go to court to battle a lawsuit brought against her by eight Discovery minority shareholders. The suit threatens to dissolve her company or force her to pay dearly to keep it; even an out-of-court settlement could prove too costly for Discovery to bear.
Ironically, Nemeth's considerable trouble stems from vexing Philip Greer, the very investor who saved her from near-ruin a decade ago. His firm, Weiss, Peck & Greer (WP&G), an investment management, venture capital, and buyout firm with offices in San Francisco, put $100,000 into Nemeth's company when it was flirting with insolvency in 1980. The cash infusion originally bought WP&G 20% of the toy concern. The firm later sold between 2% and 3% to an outside investor, leaving it with a 17.46% share. Nemeth and her husband, Ed, own about 68%.
In the decade since the deal, Discovery has become successful and Greer -- as any venture capitalist would -- has been waiting to cash out his position. But WP&G did not specifically contract for a way to liquidate its holdings, and Discovery hasn't paid out a dime either as a return or as a dividend. Nemeth's compensation, meanwhile, has risen exponentially -- from $32,000 in 1981 to $750,000 in 1989 -- serving to irk the peeved Greer even more.
Last August WP&G took its gripe to the courts, charging the entrepreneur with treating herself better than the company's minority shareholders, and so abusing their minority rights. Nemeth and Discovery countersued, alleging Greer engaged in a pattern of greenmail, harassing and badgering Discovery for an exorbitant price for the stock. In February Weiss, Peck & Greer asked for an involuntary dissolution of Discovery -- possibly the first time that a venture capital firm has sued to dissolve one of its own portfolio companies, but nevertheless Greer's only legal avenue for liquidating his firm's position. By May more barbs were flying. All but 3 of Discovery's 11 minority owners had become parties to the suit. Two of the 3 not suing are insiders: Nemeth's husband and Michael Clark, the company's chief operating officer.
That the minority should gang up on the majority -- especially in a private company whose founder owns the bulk of the equity -- is not unique to this feud. Suing for dissolution is a common cure in several states for irreconcilable shareholder disputes, particularly those springing from closely held and family-owned businesses. What's more, the courts have grown increasingly willing to favor minority shareholders and actually dissolve a company, sending a stern message to business owners who believe they can ignore those investors and enrich themselves instead.
Before California Superior Court Judge Ellen S. James weighs the issues, she'll have to wade through considerable court files. Indeed, in the past year, the battle between Discovery and WP&G has become so hostile that the lawyers for each have clogged the court with motions for sanctions and evidence of every sort, laying bare the entire history of a 10-year relationship now on the rocks.
Those documents suggest that Nemeth and Greer, acting more like star-struck sweethearts than business partners, got into a legally binding relationship without first agreeing on what they wanted to get out of it. They neither discussed common goals for the company, nor contracted for them. The court papers make plain that Greer, while a savvy venture capitalist, did not act like one when he invested in Discovery, leaving too much -- particularly his exit strategy -- to chance. And the record shows that Nemeth took the venture money despite never liking the strings attached to it. In short, Greer struck a deal that was careless in ways he would later regret. Nemeth cut one she didn't want even then, and likes less now.
Obscured by the lofty legal claims is what the two are really after. What Greer wants is money -- his financial due. He wants WP&G's stake made liquid, and the suit for dissolution is his way to force that end. If it works, WP&G could get as much as a $12-million return on its 1980 investment of $100,000.
Nemeth wants Greer out, too, but she doesn't want to pay his price to get rid of WP&G. Greer has bet a 22-year reputation to get what he wants, but it's Nemeth who's betting more. If she loses in court, the dissolution action could force Discovery to pay, in cash, fair market value for WP&G's stock -- the $12 million is a reasonable guess. Discovery representatives equivocate about whether the company would meet such a price, or if it can. But if the sum is beyond reach, Discovery goes to the highest bidder, and Nemeth could well wind up back in her garage.
In the summer of 1980, when the deal between Nemeth and Weiss, Peck & Greer was forged, none of this would have seemed imaginable.
What brought Nemeth to the table that summer was desperation. Her company had posted revenues of $927,000 for the fiscal year ending January 31 and had even registered a modest profit. But it had since run out of cash in the off-season. And on the other side of its balance sheet was $100,000 in supplier accounts payable. Unable to secure a bank loan ("The bankers asked me why my husband allowed me to work," Nemeth recalls), she was forced to factor her inventory at an effective interest rate of 27%. Three months into that deal Nemeth's supplier debts were satisfied, but she was deep into the factoring outfit instead.
As serendipity would have it, venture capitalist Greer had just weeks before found himself at a Discovery home sales party near his weekend retreat in the Napa Valley. Pedaling to the party on his bicycle, Greer, the father of two daughters, hadn't expected much. "But I was awed at the quality of the toys and the sales presentation," he recalls. "I remember thinking the business would be easy to expand." Greer returned home with $120 worth of toys and Lane Nemeth's address.
He dispatched WP&G partner Ronald J. Hall to meet with Nemeth. "I had never heard of a venture capitalist," she says. "I had never heard of Weiss, Peck & Greer. I didn't know anything about the whole Wall Street scene."
A three-month investment dialogue ensued. One sticking point: how much equity Nemeth would have to surrender to get WP&G's cash. The equity range they discussed peaked at 20%; the venture firm would fork over $100,000 for it.
Nemeth remembers bitter arguments about the issue, ones that included yelling and screaming. "Phil said I was naïve if I thought that I could get a deal for less than 20%," fumes Nemeth. "I hit the ceiling, called him a liar, unethical, and other unprintable names, and stormed out of his office." Needless to say, no one held a gun to Nemeth's head; dissatisfied with the deal's terms, she could have walked away. But she didn't. "I had nowhere else to go," she explains now. "I had not looked for money anywhere else. It was do or die. So I called him, told him I did not like him, but said I would take his money."
Hall and Greer do not recall this verbal sparring. "If such things had happened before we put our money in," says Greer, "we would not have done it. We would not have gone for that kind of treatment." Nonetheless, Hall, now the managing director of First Interstate Venture Capital Corp., in Newport Beach, Calif., and another minority shareholder suing Nemeth, admits, "There was no question that she did not want to give up equity, especially 20%. But we valued her company at $500,000 at the time and felt that it was a fair deal."
WP&G got a board seat in the agreement, plus a $10,000 fee for financial consulting services. For the fee, Hall and Greer helped Nemeth secure a $250,000 Small Business Administration-backed loan through San Francisco's Bank of America. Nemeth complains about having had to pay the $10,000 fee -- she netted only $90,000 from WP&G as a result of it -- but she pocketed $340,000 in working capital in the end, at rates more favorable than those proffered by her factor.
What WP&G did not get in the deal was a way to get its money out. The agreement contains neither registration rights for the venture firm in the event of a public offering, nor redemption rights in the case of a decision to remain private -- provisions that professional equity investors of any ilk normally require. That Greer neglected to contract for them is puzzling -- he'd been a venture capitalist for 12 years by the time of the Discovery deal and surely understood that a holding doesn't mean much to a venture capitalist if there is no way to get it liquid.
Apparently he didn't take Discovery and Nemeth seriously enough, something for which he would later be sorry. According to Hall, it was Nemeth who involved a lawyer in the negotiations, not WP&G. "At the time, Weiss, Peck & Greer was doing technology deals. Discovery was not a tech deal. And at $100,000 it was small relative to other investments," says Hall.
Greer recalls, "It would be less than fair to say I analyzed it like I would a $2-million deal. I went in because the investment struck all the right chords for me. I liked Lane, I liked the toys, the market was enormous. Things like registration rights were a long way away at Discovery Toys at the time. I did want to make a return on the investment. But we certainly did not contemplate an exit in that original document. I felt that Lane and her company were worthwhile and that it would work out. It didn't."
By 1988 it was clear that it never would, and WP&G started raising questions about shareholder liquidity; Greer wanted out. Of the allegations being leveled by Discovery, the one that wallops Greer's reputation is his supposed campaign to extract an exorbitant price for his minority position. Nemeth contends that Greer first tried to foist a public offering on the company to get fat returns; he is accused later of simply harassing Discovery's board for shareholder dividends. "The thing that is so shocking about this lawsuit," says Greer, "is that it attacks my reputation. My reputation is all I've got."
It takes a beating here. "What this case is really about is Greer's greed," Discovery's court filing states. "The real reason Greer seeks . . . relief is to bring Discovery Toys' business to a halt in order to extort a higher price for Greer's stock. . . . There is a word for what Greer wants. It is 'greenmail.' "
Whether a greenmailer or not, no one accuses Greer of being easygoing. Known for his quick mind and a probing, blunt style, he's earned a reputation for toughness in the boardroom. "Phil is a professional and deals with issues on a professional basis," says Frederick W. Smith, the founder and chief executive of Federal Express Corp., who has known Greer since 1973. "I suspect that if you are not used to dealing with businesspeople, his directness could put you off." "When Phil feels strongly about something, he will push on it," says Judy Estrin, executive vice-president of WP&G-funded start-up Network Computing Devices Inc., in Mountain View, Calif., and a cofounder of Bridge Communications Inc. John Adler, the president and CEO of Adaptec Inc., a Milpitas, Calif.-based computer peripheral controller manufacturer in which WP&G invested in 1981, adds, "I see Phil as a very serious businessman. He looks after his money."
He does so in a singular way. While most venture capitalists coinvest in deals to spread the risk, Greer is often the only investor in a company. "Phil is not clubby," observes a former Weiss, Peck & Greer partner. "We're not groupies," Greer asserts of his firm.
For its support, Weiss, Peck & Greer usually buys only a minority interest in a company. Of the 50 companies the firm counts in the funds it manages, it owns 50% or more of only 5. "We make a living from being a minority shareholder," says Greer, the precise reason that Nemeth's alleged mistreatment of him provoked him to file suit. "This business about being minority shareholders is important to me and to the firm," stumps Greer. "We are pros at this. So being treated fairly is very important to us."
Let's be clear here about what Greer has in mind when he talks about fairness. The venture capitalist is careful not to say that he'd have settled all along for measly dividends now that his $100,000 has mushroomed into millions. But the lawyer for WP&G and the other plaintiffs, Harold McElhinny of San Francisco's Morrison & Foerster, insists there would have been no need to sue the entrepreneur if she had paid the shareholders dividends proportionate to what she paid herself in excess salary and bonuses.
This is a fight about price, something Greer and Nemeth failed to reconcile. They tried. When Greer asked for the buyout in early 1988, following the end of the January 31 fiscal year in which Discovery's revenues reached $57 million, Nemeth offered $1.2 million. Greer declined, countering with a $3.3-million offer, to be paid on a schedule tied to the company's performance. She came back with a second offer of $2.2 million in April 1989. Last August Weiss, Peck & Greer sued. In its amended complaint filed last February WP&G claimed that even after Nemeth's alleged misapplication of corporate funds and personal overcompensation, Discovery had more than $8 million in retained earnings as of January 1, 1989. "Meanwhile," states the lawsuit, "no profits have been distributed to the minority shareholders."
It's impossible to be sure, but all three offers might have been below fair market value. By valuing the company at one times sales, WP&G's holdings, in 1988, would have fetched $10 million, and today perhaps $12 million. Nemeth, obviously, disputes those numbers, continuing to characterize Greer's requests as single-mindedly greedy. In any case, Discovery board member Kenneth Knight, the dean of the School of Business and Economics at Seattle Pacific University in Seattle, says, "Phil was always concerned with obtaining liquidity on terms that were favorable to him. And rightfully so. Boards should annually discuss shareholder liquidity. It ought to be on theagenda. But Phil would not say, 'Let's discuss it.' He presented it like, 'You will pay,' 'You owe it to me.' In cases like these, the issue usually comes down to price. This time we did not work it out."
If Greer and his fellow plaintiffs are to be believed, Nemeth herself is no stranger to greed. Court papers describe her treating the company's coffers as her own private honey pot, putting her husband, father, and a live-in nanny who drove a company car on the payroll. Nemeth is charged with taking an entourage, including her hairdresser, manicurist, and daughter's playmate, on trips to such places as Bora Bora at company expense. Weiss, Peck & Greer lawyer McElhinny adds to the list jewelry and clothing that Nemeth has purchased with company funds to wear to company functions. "The problem arises if she keeps it after she wears it to the show or the photo shoot," charges the attorney.
Nemeth, a onetime day-care teacher who made $12,000 the year she started Discovery, is also accused of paying herself, in salary and bonuses, in excess of $700,000 in 1989, all the while refusing to pay other shareholders a penny. Publicly she's denied the figure, but in her sworn deposition Nemeth admits her income was approximately $750,000; her base salary was $375,000, and profitability-based bonuses made up the rest.
The accusations set off the gangly, girlish, high-strung Nemeth. Sitting in her office suite in Discovery's Martinez, Calif., headquarters, she ticks off her responses. "The board has approved my compensation and my stage wardrobe," she insists. "And yes, I went to Tahiti, but on business. All of my business expenses have been appropriate. We call our financial officer 'Dragon Lady,' she is so strict. Phil has accused me of being a 'closet rich person.' Well, I don't care about huge wealth. I care about my mission, about making kids believe in themselves by growing up with quality toys."
Indeed, as she speaks, toys surround her. Furry, floppy creatures curl around her telephone; lighted glass cabinets blush with exotic and rare dolls and highlight an ordinary but cherished one from her childhood. ("I played with dolls way past when I should have," Nemeth had confessed at the conversation's start.)
She chose to accomplish her mission the hard way: by pairing the toy business with direct sales. About 18,000 field sales agents -- called educational consultants by Discovery -- hawk the company's mostly exclusive line of toys at home parties across the United States, Canada, and, since last fall, Japan. Keeping this far-flung, mostly female sales force pleased and motivated is trouble enough; turnover of field agents in the direct-sales industry averages 100% a year.
Further complicating Nemeth's task is the cyclical nature of the toy business. About 60% of the company's annual sales come in the three months preceding Christmas. It borrows on a $9 million revolving line of credit and dips into retained earnings to operate in the off-season. Says Nemeth of her risky business, "It's very scary."
That's why she claims she's never paid minority shareholders dividends: the company always needed the cash more. Nemeth professes to "live on airplanes," trooping around the country and world to whip up enthusiasm among her sales agents. She produces slick videotapes to keep them appraised of events and products. In an effort to even out the company's revenue stream and keep field agents working year-round, she plowed about $2 million into a children's book club division in early 1988. A Japan venture last year, a joint project with Shaklee Japan K. K., also cost a bundle. As a result of such programs, Roger Mertz, the company's and Nemeth's lawyer and a board member, says the company's cash position is at an all-time low.
"From the company's standpoint," says Mertz, a member of San Francisco's Severson & Werson, "the money was always needed to expand the business. If we paid dividends, Lane and Ed would get most of them -- 68%. But we felt paying them was not to the advantage of the corporation. We wanted to reinvest. We wanted to buy inventories." Nemeth concurs, "Our scorecard has never been dividends. It's kids and moms and great toys. If Phil had told me what he wanted to get out of this in the first place, we would not be in this pickle. I thought he cared about me and my company. But he only cared about money."
That she could afford to pay herself $750,000 and not pay dividends, though, raises questions about her claims. As the leader of a $70-million private toy company, Nemeth received compensation matching that reported for a vice-chairman of BankAmerica in a recent survey of northern California's 100 largest public companies.
"If she can pay herself so much, then she ought to be able to pay minority shareholders a dividend," observes Graef Crystal, professor of organizational behavior at the Haas School of Business at the University of California/Berkeley and a compensation expert. Still, he says, "It is hard to conclude if an entrepreneur is overpaying him-or herself, especially if he or she plows profits back into the company.
"In this case, she has a fiduciary responsibility to shareholders, but it's hard to make an overpayment claim stick. If she is a pig," Crystal continues, "then she is a garden-variety pig, in comparison to what some executives pay themselves. In the scheme of things, she might be called a piglet."
Philip Greer, a balding, bright, hyperactive man, sits in his office on the 47th floor of San Francisco's Bank of America building and considers how this drama will end. Among the family snapshots on a wall hang tombstones commemorating public offerings of his portfolio companies, a mayoral proclamation lauding the Schools of the Sacred Heart (of which he was chairman of the board), and a picture of Greer and his wife, Nancy, with then Vice-President Bush and Barbara Bush.
Why Greer presses the fight is easy to understand. Unless both the suits are thrown out of court, WP&G stands finally to get some money out of Nemeth. True, he's betting 22 years of hard-earned credibility to achieve that end, but so far his pursuit of the litigation hasn't hurt him: while headlines were featuring the fight nationwide, Greer raised and closed a new $95-million venture capital fund without a hitch.
He admits that if the greenmail claim sticks, his reputation will take a pounding. "People will read the papers and think, 'What kind of an aggressive, greedy greenmailing guy is this?' If they don't go beyond that, I will be hurt."
But he claims his professional integrity will remain intact regardless of the outcome and may even be amplified by it. "I'm so convinced I am on the right side, I believe so much in this minority shareholder rights issue, that I think my reputation will be enhanced by this. Suing someone is against my nature. I am 54, and I have never been involved in a lawsuit. But I happen to be right."
For Nemeth, the stakes are not so philosophical. Clearly distressed by the lawsuits, she sees the fight as an "emotional battle," not one about business ethics. "Ten years ago he should have told me he wanted to get a huge return on his investment," she stews. "I wanted a private company. He wanted to put a lousy $90,000 in and then get more out. This has hurt like hell."
She is taking the bigger gamble by heading to the courtroom. She's counting that a victory in her greenmail suit will get rid of Greer without paying him a nickel. But legal experts question the validity of Nemeth's greenmail claim. Greenmail is a notion usually involving public companies, not private concerns like Discovery. Moreover, the majority of such suits tried nationally involve greenmail that has actually been paid. This is not so in Discovery's case; if there was no harm, it might be hard to prove the foul.
If the court does not rule in Nemeth's favor and Greer's dissolution action prevails, her company would be put in financial peril. Discovery lawyer Mertz says Discovery can now pay the $3.3 million WP&G wanted in 1989, a price the company once found too steep. Nemeth and her COO, Michael Clark, on the other hand, say that a $1-million to $2-million payout would adversely affect Discovery's net worth, placing the company in jeopardy with its banks and creditors. And no one will speculate what would happen to Discovery if it were forced to pay a higher price for Greer's stock, either as a settlement or under a court order. Mertz sputters, "The company has strategies in place to deal with a higher valuation."
How will the case turn out? Mertz says Nemeth is "prepared to roll the dice" on her company despite the odds, but Nemeth may not be so daring in the end. In her deposition last spring, she identified so closely with her company that she sees herself as its embodiment. She doesn't see herself, or her family, separate from Discovery Toys: her husband works for the company, she entertains at home for the company, she wants her daughter to run it someday.
In addition to the emotional rewards, Discovery has made Nemeth rich, and perhaps more important, famous. She's the role model for the 18,000 women worldwide who sell her toys. "I don't want to say to 18,000 women, 'We're out of business,' " Nemeth says, shaking her head solemnly. "There is no way I want to be responsible for that." She may be, unless she realizes that, like it or not, Greer may walk away pocketing some money she doesn't want to part with. She may see that settling with him on the courthouse steps is smarter than chancing a verdict that would take away from her the very thing she lives for.* * *
Nancy Rutter is a San Francisco-based freelance writer who specializes in business and legal issues.
Even if your company is private, neglecting your shareholders is bad business
Minority shareholders are having their day in court, observes James D. Cox, professor at Duke University School of Law. "Areas of corporate law come in and out of fashion," says the professor. "Lively right now are takeovers and issues surrounding closely held corporations that have a handful of shareholders."
That the issues are timely won't matter much in the suit by Weiss, Peck & Greer (WP&G) against Lane Nemeth and Discovery Toys Inc., her Martinez, Calif., company. What will matter is the aggressive California law that permits ill-treated minority shareholders to dissolve a company. Only California and Ohio have such involuntary dissolution statutes, which expressly address minority shareholder rights and enable them to dissolve a corporation. New York and Delaware also have well-defined minority shareholder rights, thanks to more developed bodies of case law.
Nevertheless, the laws governing corporations in every state recognize that the majority has a fiduciary duty to treat the minority fairly and offer lawful remedies for minority mistreatment. "States may not have similar statutes, but most will put a stop to a majority activity if it is not responsible," says Jesse Choper, dean of Boalt Hall, the University of California/ Berkeley's law school.
The Discovery Toys case is an unusual one, legal experts agree. Minority shareholder court battles most commonly surround family-owned or family-financed companies, those most likely to be built on good-faith relationships, not heavily lawyered contracts. "These arrangements are often like a marriage," says Cox. "The parties go into them so optimistic. They think they will always have a cordial relationship. Then suddenly something happens to the business, to the personalities. And then the courts have to decide what happened."
The circumstances that lead to the kind of dissolution action in the Discovery case are predictable, says Kenneth Scott, a professor at Stanford Law School. "There are common kinds of impasses -- such as when the majority shareholder will not pay dividends or buy out the minority."
The involuntary dissolution action in the Discovery case provides two avenues for minority stockholders to get cash for their holdings. At the defendant's option, the court can appoint a panel of three independent appraisers, who then determine a fair market value for the stock. This stays the dissolution action.
The two sides may also argue the case to a judge -- such an action is not tried before a jury in California -- who then rules on its merits. That a company should be dissolved by the court is no longer a rarity, says professor Cox. "It used to be that courts would never dissolve a corporation. Now, it's quite the opposite. Courts have bought into the idea that they should protect the reasonable expectations by shareholders that they will be well treated."
Cox thinks the courts are more sympathetic with minority shareholders than in the past. "There was a time when the corporation and the majority were sacred cows," he explains. "But lately courts have been announcing to the majority, 'You have harmed the little guy.' The courts have, if you will, come down on the side of truth and justice, the small guy."
If the Discovery case is resolved in Greer's favor, the court won't actually liquidate the business. "Dissolution does not necessarily end the business," says Scott. "It simply ends the relationship between a particular group of stockholders. The company is actually up for sale at that point, but it's not auctioned off desk by desk. It is opened up as a whole to a competitive bidding process. Any party, including those parties who could not come to terms before, can bid on it."