When the internet bubble burst, venture financing for start-up companies became scarce. Entrepreneurs and boards often agreed to financing terms at dilutive prices that frequently called for senior preferences and multiple liquidation payments. When companies were unable to complete an equity financing and required a bridge loan from their existing investors, the payment terms often called for a return of two to five times of the loan amount. At the time, such terms could be justified when the only option was liquidation or a fire sale, and plummeting stock values gave no assurances to investors that the bottom was anywhere in sight. With the crisis atmosphere that prevailed at the time and the sense that most of the equity in these companies was permanently underwater, many companies and investors were not able to follow the most pristine of processes when it came to considering and authorizing these financing terms.
There has been a noticeable up tick in both the level of tech mergers and acquisition activity and deal valuations with the recent resurgence in the technology market. The flip side to this welcomed news is that investors and entrepreneurs who had seen their ownership interests diluted in earlier down rounds now may attempt to challenge those transactions. An example of that scrutiny is unfolding in Santa Clara, California, where Aamer Latif, a shareholder, board member and founder of Nishan Systems, Inc., has filed a lawsuit against, among others, McData Corporation, two venture capital firms and four Nishan board members. The suit alleges that the venture capital firms stacked the Nishan board and used the board to promote their own financial interests at the expense of the common stockholders. The suit further alleges that the defendants engaged in fraud in order to obtain the votes of the common stockholders needed to approve the McData acquisition of Nishan.
Latif paints an abuse of power by insiders of Nishan. Among other matters, Laitif alleges that the venture capitalists gained control of the board by not revealing certain conflicts of interest, and the board then approved bridge loans with a three times multiple return provision from some of the existing investors after Nishan had received a merger proposal from McData. Allegedly, the board also agreed that all previous bridge loans made to the company would retroactively be repaid with this three times multiple. Latif further alleges that the opportunity to participate in the bridge loan was limited to the two venture capital firms and a handful of favored shareholders, although other qualified shareholders had expressed interest in participating in the financing. At the time the bridge loans were approved, it is also alleged that the two venture firms effectively blocked the company’s access to other investors or loans from McData.
Latif further alleges that through improper influence, payment of various bonuses and, in certain cases, coercion, the defendants bought the necessary votes to approve the merger with McData. In addition, Latif alleges that the distribution of the proceeds from the McData merger as approved by the board was inherently unfair to the common stockholders. Allegedly, after the payment of the bridge amounts, the preferences to preferred holders and the various bonuses and other amounts to insiders, the common shareholders were to only receive approximately $4 million out of the $90 million merger consideration--representing approximately 4 percent of the total proceeds.
While the Nishan allegations may represent fairly extreme behavior, they do serve as a reminder that in today’s improving economic environment corporate decision-making processes and rich financing terms, while warranted under earlier circumstances, may receive heightened scrutiny. In order to minimize the risk of future challenges, companies and investors considering similar financing terms should follow sound corporate decision-making processes, including obtaining disinterested board approval, if possible, testing the market for outside investor interest, extending participation rights to qualified stockholders and seeking guidance from professional advisors.
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