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The founders' dilemma

The nasty split of Fox Paine & Company showed the industry that a founder's departure can bring a whole host of problems.

When Saul Fox opted not to participate in Fox Paine & Company's third fund, he and co-founder W. Dexter Paine III drew up an agreement whereby Fox would continue in his role of chief executive of the previous funds, and Paine would have license to use the Fox Paine name and assets for the next vehicle. The two thought it could work. But over the next three years the seemingly clear-cut agreement would end in a lengthy, bitter lawsuit, and Paine expunging Fox's name from the San Francisco firm entirely.

Before founding Fox Paine, Fox previously worked at Kohlberg Kravis Roberts. Paine was a senior partner at Kohlberg & Co., a firm formed after Jerome Kohlberg parted ways with KKR, of which he was a founder. The two set up their Foster City, California-based buyout shop in 1997, with Fox as chief executive officer and Paine as president. They raised two funds together: a $500 million debut vehicle that closed in 1998, and a $750 million fund that closed in 2000.

?Over time, beginning in 2006, FPC personnel whom Paine raided have increasingly become disrespectful of, and less responsive to, Fox in his role as CEO of the company. More and more they delay and frequently fail altogether to return his calls or report to him on developments at FPC-controlled companies to which they have been assigned monitoring responsibilities.?

As Fox describes it in the 38-page complaint he filed against Paine in the Chancery Court of Delaware last August, the two decided in late 2005 that Fox would not participate in the fundraising or investment of the firm's next fund, Fox Paine Capital Fund III. But Fox had no intention of leaving the firm. He said he wanted to continue to participate in the management of the firm's first two funds, as well as focus more attention of ?non-fund opportunities? for the firm.

How to co-habitate after a divorce? Fox and Paine drew up an agreement under which Fox granted Paine's new venture a ?limited, conditional license to use certain FPC assets, including the Fox Paine name, the non-exclusive services of certain FPC executive and professional employees, FPC's track record, databases, intellectual property, information technology infrastructure, offices, computers and access to FPC's investors.? As a precautionary measure, the two agreed that the licensing agreement would terminate ?upon any material breach of the agreement by Paine or his new venture.?

Paine went on to breach ?nearly every material term of the parties' agreement,? or so Fox alleges. Paine hired all the employees of Fox Paine, including its chief financial officer, and ?expressly told them that they were no longer employees of FPC, and made it clear to them that if they wanted to keep their jobs they were to follow Paine's instructions and ignore Fox's,? Fox said. Paine also ?used marketing materials for the new fund that impugned Fox and glorified Paine and his new venture at Fox's expense.?

The accusations continue. Paine ?secretly countermanded Fox's decisions,? put Fox Paine portfolio companies up for sale without Fox's knowledge, and attempted to sell another Fox Paine portfolio company while Fox was out of the country, Fox alleges. Paine also ?interfered with and attempted to frustrate Fox's efforts to hire a new CFO for FPC to replace the officer that Paine raided.?

Four months after the suit was filed, Fox and Paine settled out of court. Fox Paine & Company rebranded in January as Paine & Partners, and renamed Fox Paine Capital Fund III as Paine & Partners Capital Fund III, seemingly to avoid any future violations of the problematic licensing agreements.

But the issue between Fox and Paine did not seem, fundamentally, to have been a matter of ambiguity or holes in the licensing agreement, says Roger Singer, a partner at Clifford Chance who focuses on fund formation. Rather, Singer suspects that what the agreement lacked was forethought.

?One of the most important requirements is that the legal agreement fits together both with the practical realities of the operation of the business, but also with the realities of human nature and human emotions,? Singer says.

It is clear from the language of the suit, Singer says, that pride was an important factor in the unraveling of the agreement. Fox takes pains to detail Paine's alleged misuses of his name and his contacts, Paine's misrepresentations to new investors of Fox's contributions to the previous funds, and other offenses that are largely ?irrelevant to the litigation,? Singer says.

One other lesson to take away from the Fox Paine saga, Singer says, is an awareness that in drafting this sort of agreement between an exiting partner and a continuing partner, the continuing party will inevitably have more leverage. Employees who want to continue working for the firm will be working for the continuing partner, so even the most neutrally drafted agreement will inherently favor whoever controls the ongoing business. From Fox's accusations it is clear that he realized this too late in the game.

?Over time, beginning in 2006, FPC personnel whom Paine raided have increasingly become disrespectful of, and less responsive to, Fox in his role as CEO of the company. More and more they delay and frequently fail altogether to return his calls or report to him on developments at FPC-controlled companies to which they have been assigned monitoring responsibilities. In dealing with Fox personally, raided employees ? who under the agreement were to remain FPC employees ? on many occasions have treated him as someone they need not listen to and whose directions they need not take,? Fox says in the suit.

The departure of a founder is always tricky, and succession planning is a specter that is beginning to raise its head for private equity firms, as the industry's giants age. No one wants a Fox/Paine style debacle on their hands. Unfortunately, there are few good alternatives.

In the best-case scenario, the partners have worked out a prearranged agreement on the manner of their departure. This is difficult to do, since the partners cannot know at the outset where they each will end up within the firm. The terms of a partner's exit would also differ depending on whether he is retiring or leaving to pursue another venture.

If no such agreement exists, an exiting partner can either be phased out gradually, in the manner of Fox, or bought out completely. Buying out a partner's interest raises the thorny question of placing a value on his stake. Phasing the partner out gradually has similarly daunting logistical issues, but may be desirable from both a business perspective and an investor relations perspective, Singer says, since all parties will want some form of continuity.

?But maybe part of being prudent in developing these arrangements is deciding whether or not you have partners with the kind of relationships that would make that work,? Singer says. Perhaps Fox and Paine did not have that kind of relationship.

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