Prelude to Uber: The Scour Story

A Lesson in Venture Capital Negotiations

Sep 09, 2023

Introduction

In 1998, Travis Kalanick–the future CEO of Uber–and five of his buddies from UCLA were building Scour, a Napster-esque startup. During their first attempt to raise venture capital, they were sued by their investors, forced to accept terrible terms, and had 51% of the company taken from them for just $4 million.

The investors were Ron Burkle and Michael Ovitz–two formidable and experienced businessmen. They knew how to use the law and media as tools in the negotiation process, ultimately forcing Scour to choose between their terms or bankruptcy.

The Story

Before founding Uber, leading it for seven years, and being ousted in a boardroom coup, Travis Kalanick had another company taken from him by investors. During his last year at UCLA Kalanick dropped out to build Scour, a peer-to-peer file sharing site similar to Napster. In the beginning, the company was small and lean. Server costs were free (paid for by UCLA), and the team didn’t take salaries. But to scale the company, they would need capital. First, they raised a small friends-and-family round. When they burned through that, they went looking for venture capital.

The team was introduced to Michael Ovitz and Ron Burkle through a friend of a friend. Both men have impressive careers of their own that are well worth learning about. (For more on Michael Ovitz, check out his biography). Here’s how they outmaneuvered Scour at every turn to secure 51% of the company for $4 million.

1. Initial inequality of bargaining power

From the start, Ovitz and Burkle had leverage over Scour. Scour was just one of the many places the investors could park their money. Public equities, fixed income, and alternatives beyond VC all offer options for investors to get healthy returns. Even if Ovitz and Burkle were specifically interested in file-sharing internet startups, there were plenty of options. Scour, on the other hand, did not have many options. They were introduced to the investors through a mutual friend and were 350 miles south of Silicon Valley. For all they knew, the pair might’ve been the only investors they would meet.

This initial leverage that the investors had over Scour is basically an inevitability when raising venture capital. However, there are three ways that Scour could have tilted the scales in their favor: 1. By increasing the value of their company 2. By increasing the number of interested investors 3. By playing hard to get.

The single best way for a startup to increase their leverage in negotiations is to increase the value of their company. Having a killer product, a huge potential market, a great team, and good metrics all increase the expected value of a company. It also helps that this strategy directly increases the probability of a company’s success–it is a genuine goal focused on building value rather than optics.

A second strategy is to increase the number of potential investors. This is relatively straightforward, but easier said than done. It should be noted that this is particularly useful before agreeing to a no-shop clause like Scour did. If a company goes looking for other investors after agreeing to a no-shop clause, it could be sued for breach of contract. However, if other investors come to that company unsolicited, that is perfectly fine, and is likely to start a bidding war. Scour agreed to Ovitz’s no-shop clause without any other interested investors. There was no chance that outside investors would apply pressure and force Ovitz to offer more attractive terms, and the company was legally barred from trying to find them during negotiations.

A third strategy for a company to increase its leverage is to play hard to get. Travis Kalanick famously went on to do this at Uber, forcing investors to come to his office for meetings and only holding three investor meetings a day to drive scarcity. There’s more risk in this strategy, as it may involve turning away or offending potential investors. It also tends to be more successful in bull markets. In fact, hard-to-get behavior is probably one indicator of a bubble environment. Finally, this is a purely optics play. This is energy spent increasing the perceived value of a company to investors, rather than increasing the actual value of a company (revenue, profits, growth, etc.) to customers.

The best approach is to focus on increasing the value of your business, and therefore the value of the investment opportunity. But, no matter what, learning how to negotiate from an initial position of weakness is a core competency for raising money.

2. A dangerously short runway

No-shop clauses are only valid for a specified period of time, usually between 30 and 90 days.

The advice here is simple: a company should make sure their runway is comfortably longer than the no-shop period. Scour got itself into a weak position when they agreed to a no-shop clause that was valid for nearly as long as their remaining runway. At one point in the Scour negotiations, Kalanick called Ovitz and bluntly said “Look, we are running out of money.” In cases like this, investors can simply wait for a company to approach bankruptcy. The closer a company is to bankruptcy, the more it’s willing to accept any terms to get a deal done. This is exactly what happened to Scour. If the negotiations drag on, investors drag their feet, or anything doesn’t end up coming together, their should be enough money available to continue to operate the business and look for other investors after the no-shop clause expires.

3. Controlling the narrative with law and media

On April 2nd, 1999, Ovitz and Burkle sued Scour for breach of contract, alleging that the company was soliciting outside investment during the no-shop period. Now, Travis Kalanick and the Scour team have said that they waited until the expiration of the no-shop clause to speak with other investors, and therefore that the lawsuit had no merit.

We can’t know which version of events is true, so let’s talk about what we do know.

If a startup is trying to raise money and gets sued by prospective investors, it’s radio silence from any other investors. As Kalanick said, “We’ve got this really litigious hardcore dude out of LA suing us. Do you think anyone else is going to give us money? No.”

And Ovitz made sure that everyone knew about the lawsuit. Kalanick himself learned about the suit when he saw it in the Wall Street Journal. Mike Isaac, NYT reporter and author of Super Pumped, cites Ovitz’ powerful “backchannel media connections” which likely helped land this very public advertisement of the suit.

So, with a lawsuit filed and a headline in the WSJ, Ovitz eliminated any chance of Scour receiving outside investment. The company was running out of money, and was pleading with Ovitz to get the deal done. At this point, Scour was completely backed into a corner. They accepted Ovitz’ terms: $4 million for 51% of the company, giving him and Burkle majority control. Remember, the merit of the lawsuit didn’t even matter here–filing and advertising the lawsuit was enough to force Scour to acquiesce.

3. Snuffing out the oxygen

A final point on the legitimate resource consumption that fighting a lawsuit would entail. Even if Scour had cash in the bank to keep operating the business, the company would have had to spend significant time and energy defending itself in court. For most startups, focused intensely on scaling their business, that might be enough to kill them outright. This ultimately happened to Scour months later–the company declared bankruptcy after being sued for $250 billion by a group of prominent media companies. At this point, Ovitz jumped ship. He spread the message in the media that he was “increasingly uncomfortable with his association” with Scour and that he had no control over the company (despite owning 51% of it). He hired an investment banker and sold his controlling stake as soon as the lawsuit hit. He got in on his own terms, and left on his own terms.

Takeaways

1. The law and media can be tools

Anticipate that experienced and successful players will use them as such.
Cultivate your own ability to use them.

2. Understand the leverage of each party and how to increase your own

When it comes to raising money, focus on: increasing the value of the company, increasing the number of interested investors, and/or playing hard to get.
Have faith in genuine value creation over optics.

Ahmed Burdette

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