(REVISED) NEWS: Blow to OC Startup Ecosystem: Details Surrounding Arbitration Case That Stuart Frost Lost Are Likely to Have Repercussions. Frost Created an Incubator and Affiliated Funds. Both Sides Could Have Made Better Decisions, According to a Local Tech Expert….
Stuart Frost, the founder of tech incubator Frost Data Capital and three funds affiliated with it, lost an arbitration case and has been ordered to pay approximately $12 million to investors, as well as millions in attorney fees, according to court documents.
Stephen Sundvold, a retired Superior Court Judge who arbitrated the case, issued a final award in August and confirmed it in October. But terms and conditions continued to be negotiated until mid-December.
The claim was made by Hollencrest Bayview Partners (HBP) in Newport Beach and Robert Wolford, one of the managing directors of Hollencrest Capital Management, which manages the HBP fund.
Wolford and the Hollencrest fund invested $100,000 and $1 million, respectively,
Wolford invested the $100,000 in the second fund, which raised a total of $41.1 million.
The claim was filed earlier this year. It includes accusations of excessive incubator fees; using the incubator fees for personal expenses, including private school for Frost’s children in Italy, where he moved his family to for an entire year while he was supposed to be overseeing the incubator and the funds; and letting the incubator get to the point of under-capitalization and insolvency.
So, what does this ruling mean for the entire OC startup/innovation ecosystem that is chock full of incubators working tirelessly to grow and scale startups and put OC on the map as an innovation hub?
One local CEO and former attorney who’s raised significant venture capital from legitimate VC firms said it does not bode well.
“When something like this happens here in Orange County, it can do extensive damage on the willingness of companies and funds to set up here,” David Bradford told OC Startups Now.
He would know as he’s raised more than $150 million from the world’s top VC’s. He was the CEO of HireVue, which uses AI in the hiring process. He helped the founder grow that company from $1 million to $40 million a year in revenue as it became a leader in providing digital interviewing services.
He also served in C-level positions at Fusion-io, a computer hardware and software systems company, which was acquired by SanDisk in 2014 for $1.1 billion, and Novell, which created the Novell NetWare network operating system, which became the dominant form of personal computer networking from the mid-1980s to the mid-1990s. Attachmate acquired Novell for $2.2-billion, while Microsoft spent $450 million to acquire some of Novell’s IP.
Bradford is currently the CEO of FluentWorlds, an English-language learning app. While the company’s HQ are in Utah, Bradford lives in Newport Coast.
Both Sides At Fault
Bradford said “one could argue that the investors who invested with Frost made a fundamental mistake by investing in someone like Frost, who had zero fund management experience.”
“Often, you will see a former tech CEO go into fund management, but it would always be done with someone who has run a venture or startup fund,” he told OC Startups Now. “That was not the case here. So shame on the investors for trusting Frost, and shame on Frost for thinking he could do this by himself.”
Frost’s Side of the Story
Frost told OC Startups Now that it was extremely challenging to scale the business model he created – in which the incubator created companies to solve big data challenges that large corporations face, using tools like artificial intelligence and its subset of machine learning, which provides predictive analytics.
The incubator, launched in 2010 and ultimately settling in San Juan Capistrano, created 27 startups. Nine still exist, Frost said. They are now located in their own, independent offices.
One that’s still going is Swarm Engineering, which raised $1 million in seed funding from investors, including the Harvard Business School Alumni Angels. (see related story here).
Collectively, all the companies raised more than $200 million, Frost told OC Startups Now.
Frost created three venture funds. Only the first two are part of the arbitration claim. Those raised about $49 million, Frost said. And all of that was invested in the portfolio companies, aside from “agreed management fees,” he said.
(The third fund reportedly invested about $13 million into the incubator, according to the claim.)
“While some of the companies have made progress, it was definitely harder than I expected,” Frost said. “We also invested very heavily in trying to secure large corporate investments and they just didn’t work out. With hindsight, I should have continued down the founder/CEO path and not raised the venture funds, but all I can do now is to try and settle and pick up the pieces.”
The corporate investors Frost solicited — like GE and Symantec — did not invest in the funds, but several invested in some of the companies. GE, for example, invested in Maana, PingThings, Predixion and Cirro.
Frost acknowledged that he charged tens of thousands of dollars in incubator fees. He said that was because “we provided a lot of services of various kinds to the companies.” That included space, marketing and mentoring, among other services.
The claim, however, questioned whether the services Frost provided were indeed “sufficient” to justify the fees he charged.
Babur Ozden, CEO of Maana, was one who did not have a problem paying the fee, saying that the $40,000 incubator fee he was charged was a “mere fraction” of the actual worth of Frost’s services, according to the claim. Sundvold expressed incredulity at this, calling this positive assessment “incredible.”
Another accusation in the claim was the lack of exits by any of the Frost startups. Frost allegedly assured Wolford that exits were “imminent” when he first pitched to him, but they never materialized, according to the claim.
Frost told OC Startups Now that “this was a bone of contention throughout.”
“I was always careful to avoid making promises on exits,” he said.
He denied using any expenses from the funds for personal use, including in Italy.
Frost tried to use money from the funds to pay Wolford and Hollencrest’s attorney’s fees. He told OC Startups Now that he thought it was appropriate to use that money because the fund agreements allowed for that.
Sundvold disagreed, determining that even if that was allowed by the agreements, Frost was not entitled to use that money to pay those fees since his conduct essentially constituted “recklessness, gross negligence or willful misconduct.” So, Sundvold tacked on additional attorney fees.
Sundvold also removed Frost from managing the first two funds. Sundvold appointed Brian Weiss, co-founder of Force 10 Partners in Newport Beach, to manage them instead.
The status of money within those funds is confidential, Weiss told OC Startups Now on Thursday. Force 10 is a provider of financial and strategic services to challenging business situations, according to its website.
The fate of the third fund is uncertain, Frost said.
Hollencrest’s Due Diligence
The claim states that Hollencrest’s investment was made after “months of due diligence, vetting and background checks.” The claim refers to Hollencrest and its “related–party sophisticated investors.”
Wolford, along with Greg Pellizzon, another Hollencrest managing director, both declined to comment for this article.
Sundvold agreed with most of Wolford and Hollencrest’s claims. He found that Frost acted “at least recklessly and in conscious indifference and/or reckless indifference to the consequences of his actions and the rights of investors.”
And that Frost was “at a minimum, …willfully blind to or consciously disregarded the substantial and justifiable risk that his conduct would turn out to violate his fiduciary duties.”
Sundvold found Frost liable for punitive damages in the amount of approximately $771,000. That amount will be reimbursed to the first two funds and is about the equivalent of the expenses that Frost was found to have incurred in connection with moving his family to Italy for a year.
The parties engaged in arbitration because that was required as part of the fund agreements, Frost said.
In most legal systems, there are very limited avenues for appeal of an arbitration award, which is sometimes seen as an advantage because it limits the duration of the dispute and any associated liability.
Frost filed an appeal in November. While he’s skeptical of its chances for success, he told OC Startups Now that it’s essentially a “placeholder” in case settlement talks fail. He declined to comment on any strategy for negotiating a settlement.
“There are circumstances in which an appeal might be possible, but it’s certainly made very difficult,” he said.
Declined to Comment
Several other sources declined to comment for this story including Colin Holley of HamptonHolley in Newport Beach, who represented Frost and his funds; Matt Hodel of Hodel Wilks in Irvine, who represented Wolford and Hollencrest; and Anthony Howcroft, CEO of Swarm, who has known and worked with Frost for decades at various companies.
The claim accused Frost of hiring Howcroft to provide marketing services through Snow Data Capital for the sole purpose of Howcroft being able to qualify for a green card. Howcroft, like Frost, is from England.