Venture capital investors have many reasons to exit underperforming investments. For a typical venture capital fund, holding an investment in a distressed company will be administratively time consuming and divert resources from other opportunities with a greater potential to achieve a meaningful return to the funds limited partners. In these circumstances, venture capital investors may look to exit the investment through a sale of the company, even where the sale proceeds cover only a portion of the venture fund's original investment. With a right to receive the sale proceeds prior to other stockholders under their liquidation preference, venture capital investors may conclude that a sale of the company is more feasible than a put right, which may be subject to statutory limitations on the company's ability to redeem its shares. Further, as the board of directors of venture-backed companies often include members elected by the venture capital holders of the company's stock, venture capital investors may believe they have a right to approve a sale transaction, even when their liquidation preference would consume the entire proceeds of the sale.
Recent decisions of the Delaware Chancery Court, however, cast doubt on the ability of venture capital investors to seek a sale of a portfolio company as a means to exit an underperforming investment without incurring risk. A substantial litigation risk has arisen for venture-backed companies when proceeds of a sale are used to satisfy the liquidation preference of preferred stockholders and common stockholders are left with little or nothing. For companies incorporated in Delaware or any jurisdiction that follows Delaware corporate law, a board of directors dominated by preferred stockholder designees may be in breach of its fiduciary duties to common stockholders by voting in favor of a transaction that provides little or no consideration to holders of common stock.
In a 2009 Delaware Chancery Court case, In re Trados Incorporated Shareholder Litigation, the court refused to dismiss a class action suit brought by common stockholders against six directors who approved a sale of the company that yielded the common stockholders zero return. Four of the six defendant directors in Trados were elected by venture capital holders of preferred stock, while the other two defendant directors were executives who were paid cash bonuses upon consummation of the sale transaction. The plaintiff common stockholders alleged that the company's prospects were improving and a future transaction could have yielded the common stockholders a higher return. The court refused to apply the business judgment rule, which may have shielded the board from the plaintiffs' challenge, because it found the majority of the board were unable to exercise independent and disinterested business judgment on account of their ties to the preferred stockholders. Instead, the court held that the transaction should be reviewed under the more stringent entire fairness standard, shifting the burden to the board members to prove the transaction was economically and procedurally fair to the common stockholders.
"Under Trados, the board designees of preferred stockholders will not be considered independent and disinterested ... "
If, under Trados, the board designees of preferred stockholders will not be considered independent and disinterested when substantially all of the proceeds are used to satisfy their liquidation preference, then approval by disinterested directors, a committee of independent directors or disinterested stockholders may overcome a challenge to the application of the business judgment in this scenario. But these alternatives are not likely to prove effective in shielding venture-backed companies with a traditional board composition from claims like the one brought by the plaintiffs in Trados. When the common stockholders receive little or no consideration in the transaction, it is highly unlikely that they or any members of the board elected by them would approve the transaction. Moreover, another recent Delaware Chancery Court case makes obtaining the vote of independent directors in favor of the transaction problematic.
In a 2010 case, LC Capital Master Fund Ltd. v. James, the Delaware Chancery Court reaffirmed that, under Delaware law, when the rights of preferred stockholders are contractually provided with respect to a transaction, a company's board of directors has no obligation to provide further fiduciary consideration to the preferred stockholders. In LC Capital, the preferred stockholders challenged a merger on the basis that the proceeds to be received by the preferred stockholders were insufficient. In an unusual circumstance for a venture-backed company, the company's certificate of incorporation in LC Capital did not grant preferred stockholders the right to vote on the merger, but rather provided the company with a right to force the conversion of the preferred stock into common stock in connection with the transaction. As a result, the liquidation preferences of the preferred stockholders did not apply. The preferred stockholders sought to enjoin the merger, alleging that the board of directors had a fiduciary duty, rather than a contractual obligation, to consider the value of the rights of the preferred stockholders outside the merger context, including their liquidation preference and dividend rights, and allocate more of the merger consideration to the preferred stockholders. The court declined to enjoin the merger, concluding that once the contractual rights of the preferred stockholders are fully satisfied, the board's fiduciary duties are owed solely to the common stockholders.
"LC Capital may provide a basis for an independent director to vote against a transaction similar to the one at issue in Trados."
It is tempting to dismiss the holding in LC Capital because venture capital investors can require a right to vote on and receive at least their liquidation preference from the proceeds of a merger when negotiating their original investment in a portfolio company. Beyond the specific facts of the case, however, LC Capital may provide a basis for an independent director to vote against a transaction similar to the one at issue in Trados. In light of LC Capital, where the contractual rights of the preferred stockholders do not mandate a sale, and the common stockholders will receive little or no consideration, it is difficult to see how an independent director can approve the transaction in a manner consistent with the fiduciary duties a director owes to the common stockholders.
Responding to the Trados case, the National Venture Capital Association (NVCA) modified its model form investment documents to provide venture capital investors with additional, contractual alternatives to protect the board of directors from Trados like claims. In their model Voting Agreement, the NVCA inserted a sales rights provision, allowing certain holders of preferred stock to cause the company to initiate a sales process. In the event a sale is identified in the sales process, but not approved by the board of directors, the preferred stockholders would have a right to sell back their shares of preferred stock to the company in exchange for their liquidation preference.
It is unclear, however, whether the sales rights alternative offered by the NVCA provides a solution to the problem created by Trados and LC Capital. Ultimately, the board of directors must approve the sale transaction identified in the sale process. Directors elected by venture capital holders of preferred stock are no more independent or less disinterested on account of the exercise of the preferred stockholder right to force the company to initiate a sale process. It will be similarly problematic for independent directors, or a committee of independent directors, to vote in favor of a sale that leaves common stockholders with little or no return. The suggested sales rights provision also fails to address the potential legal limitations on redemption of stock under Delaware law, in particular where the company is distressed and less likely to have the financial ability to redeem the preferred stock without a sale of the company, which requires consent of the board of directors.
In addition to the sales rights provision, in new commentary to its model form Voting Agreement, the NVCA suggests that venture capital investors consider eliminating the requirement that a company's board of directors approve a sale transaction before the preferred stockholders may exercise their drag-along rights. Under a typical drag-along rights provision, all stockholders are contractually obligated to participate in and approve a sale transaction provided certain conditions are met, usually the prior approval of the transaction by the company's board of directors and preferred stockholders. Without the prerequisite board approval, preferred stockholders would have a contractual right to mandate a sale of the company unilaterally. This approach has significant issues as well, as it may not be feasible to have every stockholder execute an appropriate agreement, and a purchaser may want to acquire the company in a merger or sale of assets, either of which will require board approval under Delaware law notwithstanding the drag-along rights of the preferred stockholders.
It remains to be seen whether the NVCA's suggested approaches will be widely adopted or prove effective in addressing the issues raised by Trados and LC Capital. Although there is currently no general consensus on how venture capital investors should address these issues, investors should be mindful of these recent developments in structuring new investments.www.cozen.com
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