Most rational businesspeople believe that their downside exposure to an investment is the value of the investment. Limited liability organizations are set up to do what their names suggest: limit liability.
That's what makes capitalism great -- the risk-taking that is encouraged by a belief that if everything goes to pot, you'll still own the house, the watch, and the car, and you can start over again. Of course, we don't allow complete chicanery, so that the law allows "piercing the corporate veil" to chase after the hooligans behind a company if, for example, the company is an insufficiently-funded sham, or the company has acted fraudulently. These exceptions to the spread of liability, are narrow, however, and well-known, so that investors (venture capitalists among them) can avoid trouble simply by operating on auto-pilot.
There may be a new exception, and it's a big one. Specifically, in mid-July a federal judge in California refused to dismiss a lawsuit by several record companies against venture capital firm Hummer Winblad based on its minority ownership stake in battered file sharing service Napster. Napster had to shut down after the same judge found a likelihood that its peer-to-peer file sharing service violated the record company's copyrights. Although the case ended because Napster's true liability could be determined, Hummer Winblad's $13 million investment in the company opened it up to a direct lawsuit from the record companies.
The legal theory is fairly unique, but not entirely novel: Hummer Winblad carries vicarious liability for Napster's actions because it installed two of its partners on the Napster board, and installed one partner as Napster's CEO (and he kept his position at Hummer while serving as CEO). Because Hummer Winblad was in a position to stop Napster, and benefitted from Napster's supposed (but not yet proven) bad actions, Hummer Winblad should pay up.
The district court's ruling is only preliminary however; it indicates that the record companies' legal theory is valid, but it says nothing about whether they can prove up their case under that theory. Thus, we simply need to watch and wait while they proceed through the "discovery" phase of the litigation (which will likely end with another dismissal motion by Hummer Winblad).
While some derive a certain masochistic glee from others' pain, the smart money simply learns from others' mistakes. So what is the lesson here? With privileges (control) come responsibilities (liabilities). You learned the lesson as a teen, and you should remember it as an investor. The more control you want to exert over an organization, the more you will need to pay attention to liabilities that organization will exert on you. This is particularly true for companies living on the legal edge, such as peer-to-peer file sharing companies that are likely to face other copyright claims. Finally, call your attorney when you have concerns -- it's simply good preventive maintenance. In sum, when you start a high-tech company, there's no free launch.
John A. Dragseth is a Principal in the Twin Cities office of Fish & Richardson, where he practices patent law. He can be reached at 612 337-2550 or firstname.lastname@example.org.