Delaware Supreme Court Provides New Guidance for Directors and Officers Evaluating a Corporate Sale or Restructuring

A recent decision by the Delaware Supreme Court, Gantler v. Stephens, C.A. No. 2392 (Del. January 27, 2009) (available here) provides new guidance for directors and officers on their fiduciary duties arising in connection with a possible corporate sale or restructuring. In Gantler, the Court held that directors and officers of an Ohio bank (the “Bank”) could be found to have breached their fiduciary duty by rejecting an opportunity to sell the Bank and instead pursuing a recapitalization that favored the insiders. The case was brought by a former director (Gantler) and minority shareholders of First Niles Financial, Inc. (“First Niles”), the Bank’s holding company.



In short, the historical position under Delaware corporate law has been that certain conflicts of interest of insiders (such as trying to keep one’s employment or directorship) are inherent and unavoidable, and if properly disclosed, would not result in a higher level of scrutiny from courts over board decisions. Gantler holds that this is not always true, and that specific facts can alter that position.



Specifically, where directors and/or officers are -- or with 20/20 hindsight, may be argued to be -- motivated to prefer one particular transaction over another, even if the motivation is reasonable and disclosed to shareholders, extreme care should be taken to ensure that the board evaluation and deliberation process is balanced and well-documented. Failure to do so may prevent a board from being entitled to the business judgment rule and subject the directors and officers to a stricter standard that the actions meet the “entire fairness” test under Delaware law.



After a strong acquisition market, in August 2004, the First Niles board agreed to put the Bank up for sale and hired investment bankers to pursue the opportunity. Shortly thereafter, the managing officers of First Niles (and the Bank), several of whom were also directors, advocated that the Bank abandon the process and privatize the company by delisting from the NASDAQ SmallCap Market. The Bank received offers from three strategic purchasers, each considered by the bankers to be within the recommended range. Two offers made clear that the purchaser would terminate the incumbent First Niles board upon closing. In the months that followed, management did not respond to the bidders’ due diligence requests and delayed the process (resulting in the withdrawal of one bid, which was not disclosed to the board until after the fact) and continued to discuss the privatization proposal. In March 2005, notwithstanding a favorable opinion from the bankers as to one of the offers, the board voted 4 to 1 to reject the offer, with Gantler being the only dissenting vote, and turned its attention to the privatization plan.



In April 2005, management presented to the board its privatization proposal, which would reclassify the First Niles common stock held by holders of 300 or fewer shares into a new class of Series A Preferred Stock that would pay higher dividends and have the same liquidation preference as the common stock, but that would not have voting rights except in the event of a proposed sale of the company. In December 2005, the proposal was approved 3 to 1 by the Board, with Gantler again being the only dissenting vote. Shortly thereafter, Gantler was replaced on the Board by an officer of the company. The following June, the newly-composed First Niles Board unanimously approved a charter amendment to effect the reclassification and proceeded with the proxy solicitation process for shareholder approval. The proxy statement did disclose that the directors and officers had a conflict of interest with respect to the reclassification and the alternative transactions that the board had considered, including a business combination that was turned down.



Following shareholder approval of the charter amendment, the plaintiffs brought suit in the Delaware Chancery Court alleging, among other things, that the board violated its various fiduciary duties by sabotaging due diligence and abandoning the sales process in favor of their own incumbency. In March 2008, the Chancery Court dismissed the case for failure to state a claim and the parties appealed.




In reversing the Chancery Court’s dismissal, the Supreme Court clarified several issues of Delaware corporate law, including the following:



§ Higher Scrutiny for Transactions with Potential Conflict of Interest. The Court agreed with the defendants that the Board’s duty in this case should be analyzed under the more favorable business judgment rule, as opposed to the “enhanced scrutiny” standard under Unocal.



However, the Court did hold that the business judgment presumption could be rebutted in this case because reasonable inferences of self interest could be drawn from the defendant directors’ and officers’ lack of cooperation with the due diligence requests and sabotaging of the bid process. In its analysis, the Court highlighted the specific conflicts arising from a sale of the Bank for each of the directors -- the potential loss of employment for the Chairman/CEO; and the loss of the Bank as a key client for businesses operated by two different directors. It is also interesting to note that the Court relied on the disclosure in the proxy statement of the potential for conflict of interest as an admission that the conflict did in fact exist.



There can be little question that the extreme facts of this case heavily influenced the Court’s decision to rebut the presumption of good faith by the board, and that the outcome may have been different if the some of the “sabotaging” activity was not present and if the board deliberations regarding the sale proposals were more extensive. The Court specifically noted that after only one bidder remained and the bankers opined that the bidder may continue to improve their offer, the board did not discuss the offer at one meeting and rejected in another, “without discussion or deliberation.”



If directors or officers do have personal financial interests that diverge from the interests of other shareholders, a board should now be prepared for a higher standard of review of their actions. That said, Gantler should not be read to require a board to reach any particular decision (e.g. sell, recapitalize, etc.), but only that the process to reach that decision is fair and informed. Therefore, to the extent that certain opportunities can later be reasonably argued to have been more preferable for certain (minority) shareholders, boards should be advised to more carefully evaluate those opportunities and to document why they may not have been in the best interests of all shareholders.



Where a potential conflict does exist, boards should be advised to consider the appointment of an independent committee for the M&A process, where such committee would have the authority to engage its own advisors and independent legal counsel. Another approach may be to engage multiple investment banking advisors to provide a board with a comparative analysis of the opportunities. Finally, extreme care should be take to distribute all studies, reports and materials in advance of board meetings, to have substantive discussions on those issues at the meetings and properly memorialize in the minutes to evidence that the board fulfilled its duty of care (which it would seem was not met in Gantler).



§ Fiduciary Duty of Officers equal to that of Directors. As an issue of first impression, the Court held that officers of a Delaware corporation have the same fiduciary duties as directors. While this position has been implied, the Supreme Court has now explicitly held that officers owe fiduciary duties of care and loyalty that are the same as those of directors of Delaware corporations.



§ Shareholder Ratification Limited. The Court also disagreed with the Chancery Court’s finding that the shareholder approval of the privatization plan, as submitted by the First Niles board and described in the proxy, “ratified” the prior actions of the board, absolving them of liability. To clarify this area of the law, the Court imposed a number of specific limitations on this doctrine.



First, shareholder ratification is effective only where a “fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become more legally effective.” Therefore, where a shareholder vote is otherwise required – such as for the approval of a charter amendment or a merger – the shareholder vote does not carry any ratifying effect of the preceding board action.



Second, the only director action that can be ratified is that which shareholders are specifically asked to approve. For example, the ultimate approval of a merger by shareholders does not mean that shareholders have also ratified all related director actions, such as defensive measures that may have been taken in the context of that transaction.



Third, the effect of shareholder ratification does not extinguish all claims in respect of the ratified director action, but rather subjects the challenged action to business judgment review (as opposed to the entire fairness test). Therefore, companies should not assume that a valid shareholder vote would sanitize the prior actions of a board in connection with any particular corporate decision or transaction.

Delaware Supreme Court denies standing to directors to bring derivative action

A recent Delaware Supreme Court decision rules that directors who are not otherwise shareholders of a corporation do not have standing to bring a derivative claim on behalf of the corporation.

The case involved claims by the plaintiff director that the other directors of the corporation were controlled by a single shareholder, who was also the corporation's CEO and Chairman. The Court held that such standing was not expressly provided by the Delaware statute, and refused to judicially extend such standing pursuant to equitable doctrine.

The decision discusses commentary from the ALI (American Law Institute) specifically recommends that such standing be extended to directors. The Court refuses to adopt this standard in Delaware, while noting that the ALI proposal has only been adopted in one state, Pennsylvania. The Court also referenced the New York corporate statute as being unique in providing directors with a statutory right to sue other directors of the corporation. (I guess that's another reason not to incorporate in New York, if you need one).

Delaware Supreme Court rejects theory that creditors may directly sue Boards of insolvent corporations for breach of fiduciary duty

A strong decision last week by the Delaware Supreme Court, NACEPF v. Gheewalla et al., protecting the boards of insolvent companies from creditor claims, may be another significant reason to incorporate in Delaware.

"Zone of insolvency"... Ahh. Makes me wistfully think back to the days of F*ckedCompany.com, circa 2002, sitting in scores of board meetings of companies that were soon to meet their maker. You all know the typical scenario. Company X raises %10-15M of venture capital in one or more rounds, market adoption slows and investors decide that another investment is probably not prudent. So they gently get out of the way, letting the management know that they won't lead the next round but would follow another lead. Burn rate is at a pretty good pace, and management ignores the VC body language, assuming that the cache of their past investors will help find new ones quickly, and that a follow is just as good anyway.

When things don't work as planned, and cash starts to get real tight, a board meeting is called where a new lawyer from your corporate law firm appears - their bankruptcy guy - and tells you that you probably need to shut the company down, or face potential claims from creditors because you are now in the "zone of insolvency". What is that, you say? Well, generally, the "zone" is when a company cannot pay its debts when they become due, such as payroll or vendor payables, etc. So now, he claims, you will face claims from creditors who don't get paid unless you shut the company down now, while there is still money left to pay. You shrug because that state probably describes the company from day one, so that just cannot be case. Otherwise, how do companies get started?

Unfortunately, this issue has plagued startups for the last decade, and probably has resulted in a good share of startups being shut down, when they may have made it in the end. Last week, the Delaware Supreme Court put an end to the dilemma by holding, in no uncertain terms, that "the creditors of a Delaware corporation that is either insolvent or in the zone of insolvency have no right, as a matter of law, to assert direct claims for breach of fiduciary duty against the corporation’s directors."

The Court agreed with the Chancery Court in its reasoning that “an otherwise solvent corporation operating in the zone of insolvency is one in most need of effective and proactive leadership—as well as the ability to negotiate in good faith with its creditors—goals which would likely be significantly undermined by the prospect of individual liability arising from the pursuit of direct claims by creditors.”

Because this has been such an important issue for academics and practioners alike, the Court noted that "the need for providing directors with definitive guidance compels us to hold that no direct claim for breach of fiduciary duties may be asserted by the creditors of a solvent corporation that is operating in the zone of insolvency. " When a solvent corporation is navigating in the zone of insolvency, the Court emphasized that the focus for Delaware directors does not change: " directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners."

It is important to note that this decision does not completely eliminate Board liability for any claims, but just those claims that are "direct" claims brought by the creditors. In general, claims against a Board can be direct or derivative, depending on a myriad of factors, including how and to whom the harm occurs. A derivative claim is a claim brought by the corporation that has suffered from the misconduct of directors, and typically must be reviewed by an independent committee as to whether the claim is a valid one. Therefore, while the NACEPF decision does leave room for creditors to bring derivative claims, the risk is diminished that the threat of such an action would chill board members from continuing to serve and from making hard decisions in distressed circumstances.

Best state for incorporation

The folks for www.askthevc.com have a good post on best state for incorporation if you are thinking about venture capital. I agree that Delaware is really the best choice, but there are variations. I also am not a huge fan of Massachusetts, which, unlike Delaware, still has the annoying procedural requirement that they need original signatures for an effective filing. Another issue with Massachusetts is that you have to opt in, in a written provision in your charter, that shareholder consents do not have to be unanimous to be effective. If you forget to do this when you form the Company, you have to chase every shareholder, or call a meeting - which creates additional issues at closing that people don't always plan.

I think another interesting topic is choice of entity. Most vcs dont favor LLCs, and yet that may be the right structure. Perhaps I will take that on in a future post.

Recent Massachusetts decision on director and shareholder duties

A recent decision by the Massachusetts Superior Court for Suffolk county (Boylan v. Boston Sand & Gravel Co., 2007 WL 836753 (Mass.Super.) has a very good synthesis of duties owed by directors and stockholders of Massachusetts corporations:

"[The defendants] as directors of [the company] , owed a fiduciary duty to the corporation, which included both a duty of care and a duty of loyalty. Demoulas v. Demoulas Super Markets, Inc., 424 Mass. 501, 528 (1997). Since they were both directors and shareholders of [the company] and since [the company]was a closely-held corporation, they owed their fellow shareholders, ..., “substantially the same duty of utmost good faith and loyalty in the operation of the enterprise that partners owe to one another, a duty that is even stricter than that required of directors and shareholders in corporations generally.” Id. at 529; Donahue v. Rodd Electrotype Co. of New England, Inc., 367 Mass. 578, 592-594 (1975).

*7 If [the defendants] wished [the company] to engage in a self-dealing transaction ... they must:
1. make full and honest disclosure of all the known material facts of the proposed transaction, including the details of the transaction and their conflict of interest; Demoulas at 531. See Puritan Medical Ctr. Inc. v. Cashman, 413 Mass. 167, 172 (1992); Dynan v. Fritz, 400 Mass. 230, 243 (1987) (“good faith requires a full and honest disclosure of all relevant circumstances to permit a disinterested decision maker to exercise its informed judgment”); ALI Principles of Corporate Governance § 5.02(a) (1994); and
2. “then either receive the assent of disinterested directors or shareholders, or otherwise prove that the decision is fair to the corporation.” Demoulas at 533. The burden of proving that the assenting directors were disinterested rests with the self-dealing directors, see Houle v. Low, 407 Mass. 810, 824 (1990), as does the burden of proving that the self-dealing was “intrinsically fair, and did not result in harm to the corporation or partnership” if the transaction was approved by self-interested directors. Demoulas at 530-531, quoting Meehan v. Shaughnessy, 404 Mass. 419, 441 (1989).


If the self-dealing directors fail to provide full disclosure of the material facts of their proposed transaction, then they breach their fiduciary duty by proceeding with the transaction, regardless of its approval by the Board or its fairness to the corporation. See Geller v. Allied-Lyons PLC, 42 Mass.App.Ct. 120, 128 (1997) (“full disclosure of all material facts respecting the finder's fee agreement [is] a prerequisite for enforcement”). The Board's approval is vitiated by the failure of full disclosure.

If the self-dealing directors provide full disclosure to the Board and the transaction is approved by the disinterested directors, then the decision enjoys the deference provided by the business judgment rule. See Harhen v. Brown, 431 Mass. 838, 847 (2000). If the self-dealing directors provide full disclosure to the Board and the transaction is approved by self-interested directors, the decision does not enjoy the benefit of the business judgment rule and must be demonstrated to be fair to the corporation. Demoulas at 533."

Study for West Coast VC Deals in Life Sciences

Fenwick publishes a quarterly study of VC deal activity in various areas. The most recent life sciences report can be found here: http://www.fenwick.com/vctrends/LS_VC_Survey_2006.htm?WT.mc_id=LSVCS_032707_e-mail-corp

Delaware Chancery Court rules on post-closing adjustment dispute

A March decision of the Chancery Court in Matria Healthcare v. Coral SR LLC is an essay on post-closing adjustment (true-up) provisions and the interplay of dispute resolution mechanisms in a purchase agreement.

The case involved a merger between two companies in the disease management and wellness business, Matria and CorSolutions. Apparently, before the closing CorSolutions received some complaints from a key customer about their bill and failed to disclose that to the buyer. Matria got the call from the customer - one day after closing - and then spent the next six months negotiating what turned into a $4 million settlement. This was done without discussion with the seller and without their consent. After the settlement, Matria sought relief from the seller for their payment and the dispute ensued.

To complicate things, this agreement had four different types of dispute and resolution mechanisms, two of which are relevant here. The first was a typical post closing adjustment (true up) provision relating to balance sheet adjustments for things like working capital, cash on hand, indebtedness, etc. Disputes arising from adjustments would be submitted to an outside accountant (a “Settlement Accountant”). These claims were not limited by a cap and would be adjusted on a first dollar basis.

Other claims by the parties relating to the transaction, such those arising from breaches of representations, warranties or covenants, would be handled by a AAA arbitration. These claims would be resolved against a $20 million escrow fund, and were subject to a basket (i.e. deductible) of $4.5 million. The agreement also provided a typical exclusive remedy clause where all claims other than fraud or for injunctive relief would be limited to the escrow fund.

The court noted that, in anticipation of a potential hierarchy issue stemming from the different ADR provisions, the parties also provided that any claim that could be brought related to the financial statement adjustments will be subject to that provision and not subject to the escrow fund. ("The items set forth on or reflected in the [financial statements delivered in connection with the true-up] and any matters relating thereto that could have been subject to adjustment or dispute pursuant to [the true-up] are subject solely to the adjustments set forth in Article II [i.e. by the Settlement Accountant] . . . and accordingly shall not be subject to any claim by [Matria]… on the Escrow Fund.”)

If the claim went before the Settlement Accountant, Matria may recover fully on its $4 million claim; if it goes before the AAA, they will likely get nothing since it will be wiped out by the $4.5 million basket. Therefore, it is not surprising that the parties could not agree on the forum.

The interesting part of this decision is the analysis of how Matria’s claim arising from the customer complaint could be characterized under the agreement. The Court noted that the claim could be (1) a potential claim, serious enough to be reflected on CorSolutions’ balance sheet, and therefore properly before the Settlement Account on a first dollar basis; (2) a misrepresentation based on a failure to disclose and a breach of various representations and warranties and, thus properly before the AAA and subject to the cap and basket ; and (3) a Third-Party Claim pursued by the customer, where yet a third mechanism from indemnity and damage relief would apply. The discussion appears on pp. 15-16 of the decision.

At the end of the day, the court being predominately known for its strict construction, directed the dispute to the Settlement Accountant on the basis of the hierarchy clause that was in the agreement, albeit with some reluctance. (“The result reached here is, in large part, unpalatable; it is the product, however, of words chosen by sophisticated parties who drafted a complex and comprehensive agreement. More importantly, it is not for some judge to substitute his subjective view of what makes sense for the terms accepted by the parties.”).

The moral of the story here is that these are very complex provisions that really need to be tested by the drafters in advance to make sure that they will work in the field. The Matria decision has a lot of other interesting nuggets for transactional lawyers relating to arbitrability, contract constuction and drafting examples (that may or may not work, depending on one's viewpoint) and therefore worth a closer a read.

Federal court rules for Buyer in earnout case

Earnouts are rife with controversy. While they are popular in today’s deal market, and most parties see them as a creative remedy to bridge a pricing or funding gap, the majority fail and result in disputes. Assuming the best of intentions to honor the original agreement, it is impossible to predict all of the parameters that may impact a future earnout potential. A recent decision by the US District Court for E.D. of Wisconsin, Didion Milling, Inc. v. Agro Distribution, LLC (2007 WL 702808) is a good primer of some the issues that may need to be tested at the purchase agreement stage.

The earnout here was based on a net cash flow determination, where the APA provided a list of guidelines on how it would be calculated, including a reference that GAAP would be used. Despite a provision in the APA that the agreement could not be assigned, the buyer assigned the agreement to another entity, which in turn assigned it again, so that the party owing the earnout was not the original buyer. Since the earnout was based on a calculation of the original business acquired, this complicated the earnout calculation not to seller’s liking.

One issue was that net cash flow was supposed to take into account after-tax numbers. The original buyer was a corporation, so it paid its own taxes. The ultimate successor was an LLC, a pass-thru, so the tax rates and rules would be different, and would not be paid by the business but by its members. This created ambiguity as to whether taxes should be included, and if so, how much. This is probably something that, now with 20-20 hindsight, should be addressed specifically in the purchase agreement.

The parties disagreed as to the interest deduction against the earnout calculation, and whether the buyer’s overall cost of capital can be used to apply across the board. Again, probably something that can be spelled out in advance, at least by plugging in numbers for min/max.

Finally, this case also involves a claim for good faith and fair dealing, which is common in earnout cases. To provide the flavor what is usually alleged, the plaintiffs claimed that each of the following was a separate reason to find bad faith: (1) buyer acquired the business aware that seller had not consented to the assignment; (2) buyer focused on reselling the business rather than operating it; (3) buyer failed to provide seller with monthly financial statements; (4) buyer failed to provide seller with the documentation necessary to support calculation of net cash flow; and (5) buyer engaged in “sharp dealing” by assessing taxes, charging interest, and early expensing of payment. The court rejected all of these as a matter of law.

A couple of these deserve comment. On the consent issue, the court noted that while a good faith claim did not work here because the ultimate buyer had no privity with the seller under the original seller, there could be a claim for intentional interefence with a contract (which was not alleged here).

On “sharp dealing”, the court explained that a party may violate the duty of good faith by taking deliberate advantage of another party’s oversight. Such sharp dealing may or may not be actionable in tort. Actions such as avoiding an unbargained for expense or obtaining an advantage by way of exploiting superior knowledge do not, however, constitute sharp dealing or a breach of the duty of good faith.

Second Circuit rules that auditors have duty to correct past opinions

A recent ruling against a small accounting firm by the Second Circuit Court of Appeals may have broad implications for the accounting industry. In Overton v. Todman & Co., investors in a privately-held company brought an action for securities fraud under Section 10b-5 against the company's auditor. They alleged that the financial statements were wrong and the auditor's opinion that the statements were correct was false when made. While New York Southern District dismissed the case, the Second Circuit appeals court reversed the decision, holding that the auditor may be held primarily liable for federal securities fraud.

Specifically, the Court held that an accountant has a “duty to correct” the opinions and statements that it issues and violates that duty and becomes primarily liable for securities fraud when it:

(1) makes a statement in its certified opinion that is false or misleading when made;
(2) subsequently learns or was reckless in not learning that the earlier statement was false or misleading;
(3) knows or should know that potential investors are relying on the opinion and
financial statements; yet
(4) fails to take reasonable steps to correct or withdraw its opinion
and/or the financial statements; and
(5) all the other requirements for liability [for securities fraud] are satisfied.

The court also noted that accountants can also be held primarily liable if they assume the role of an insider in the company. ("[I]f the accountant exchanges his or her role for a role as an insider who vends the company’s securities, then the accountant shares in an insider’s duty to disclose.")

The Court attempted to limit the impact of this decision by holding that the duty to correct was not implying that theere was a duty to update its past opinions. ("The duty to correct requires only that the accountant correct statements that were false when made. In contrast, the duty to update requires an accountant to correct a statement made misleading by intervening events, even if the statement was true when made. ") Immediately following that statement, however, the Court cited a case for the proposition that "in limited circumstances, an issuer may have 'a duty to update opinions and projections . . . if the original opinions or projections have become misleading as the result of intervening events'").

While the allegations in this case are a bit extreme, this case may have wide-reaching potential to create a new level of hedging (and CYA memos and disclaimers) for the accounting industry. The court's mere hinting that there could be situations where an auditor could be held liable where it knew or should have known about an issue that needed updating places both accountants and young companies they represent in a tough spot. The decision suggests that accountants are only liable if they make a statement (i.e. issue an audit opinion), which is a sine qua non for many companies in raising their first and following venture round. Accountants (like lawyers) also often play a significant role in the business of a young or small company, i.e. act as insiders, and this case suggests that liability awaits. I guess no good deed goes unpunished! If other courts follow, both accountants and lawyers may really need to limit their role as company business advisors for mitigate potential exposure to these types of claims.

Indemnification rights in venture deals

While the venture market still seems flush with cash, a number of recent litigations involving venture firms (such as the Hummer Winblad case now in seemingly constant discussion) are driving the market to seek additional protections from their portfolio companies upon investment and afterwards.

In particular, some investors are now asking for indemnification from the company akin to the measures in an acquisition agreement. Companies looking to oppose these provisions should know that they are generally rare. While an indemnity is market where the deal presents some liquidity to the founders or other investors. this is not common in the venture context. The VC investors typically have board seats, observation and information rights and strong covenants, so they are in a position to see how the money is spent. If they don't have then, this presents a bargaining chip for the company in exchange for the indemnity being sought. They also have the right to sue the company for breach of the reps or fraud while there is still money to pay the claim. Unlike an M&A deal, venture round docs usually don't have exclusive remedy clauses.

A later stage financing certainly is more likely to give concern to the investor about the unknown that cannot adequately be tested through due diligence, but it would be unfair to shift that risk to the founders. If I am a VC asking for this provision and getting it regularly, I have to ask kind of company (and founder team) am I investing in if they will accept those terms. The
better the terms for the VC, the more apparently becomes the adverse selection problem.

One way to deal with the issue is to ask the investors their specific concerns. If there is a known problem, such as a litigation, a 409A problem, etc., that can be dealt with through traunches, escrow etc, without personally impinging on the Founders . The NVCA model docs address this issue parenthetically by having certain reps be made by the Founders, where the "Founder's liability for breaches of any provisions of this Section 3 shall be limited to the then current fair market value [as determined in good faith by the board of directors of the Company and such Founder [may, in his sole discretion, discharge such liability by the surrender of such shares or the payment of cash] (note FN1 and FN2 below from the docs). The NVCA docs are intended as a fair starting point for a Series A round, and they do not contemplate an indemnity. Finally, another approach may be to allow the indemnity, but to limit all recourse to the Founder's shares. The risk here, of course, is the precedent for the next round.


[1] Founders' representations are controversial and may elicit significant resistance. They are more common in the Northeast and counsel should be warned that they may not be well received elsewhere.
They are more likely to appear if Founders are receiving liquidity from the transaction or if there is heightened concern over intellectual property (e.g., the Company is a spin-out from an academic institution
or the Founder was formerly with another Company whose business could be deemed competitive with the Company). Founders' representations are not common in subsequent rounds, even in the Northeast, where risk is viewed as significantly diminished and fairly shared by the investors rather than being disproportionately borne by the Founders.

[2] Investors should consider whether cash is an acceptable remedy; the cash value of the shares is likely to be low, particularly if there has been a breach of a rep or warranty. In addition, if the Investors require the surrender of shares rather than cash, they should also consider whether to include Preferred Stock, as well, if the Founder owns shares of Preferred.

Fourth Circuit Court of Appeals opines on earnout in roll-up case

To take a little break from recent posts on Delaware case law, I thought I would comment a little on a new decision by the Fourth Circuit involving an earnout provision. The case, Vaughan v. Recall Total Information Management, can be read here. Vaughn involves a failed earnout in a roll-up acquisition and presents an interesting case study.

Earnouts have become prevalent in today's M&A environment. Buyers often are cautious about projections offered by sellers and rely on earnouts to reach a middle ground. The difficulty lies in agreeing on earnout targets and formulas. Sellers typically prefer to measure in terms of sales/revenues, while buyers want to measure actual profitability of performance, often using relying of EBIDTA or net income as a metric. While an earnout may be a decent option for a seller that intends to stay involved in the business, for a business owner (such as financial investor) that truly wants an exit, it presents a substantial risk. Conversely, buyers are often at risk for being a target for litigation when things go wrong and targets are not met.

The Vaughan case illustrates some of the potential problems with earnouts. Seller (SDA) ran a successful document shredding business that was acquired by Buyer (Recall). The total price was approximately $27 million, with almost $12 million being subject to an earnout payable in two installments over 12 months after closing. The earnout formula was based on sales revenues of buyer, and to earn the full earnout, the revenues for the acquired business would need to increase almost 50% over the 12 month earnout period. This aggressive target, together with heavy weighting of the earnout (app. 40% of the total price), put this deal in a high risk category.

Not surprisingly, a key issue in the litigation was whether seller was entitled to count certain sales revenues of buyer toward the earnout. After this acquisition, Recall acquired a number other document shredding companies. A key question became exactly who was responsible for the acquisitions, and for the revenues they ultimately delivered. The Agreement defined Sales Revenue broadly, to include "all gross revenue generated by the Company from new contracts or agreements from any source for document shredding services." The earnout provision in the Purchase Agreement also placed an express duty on the Buyer to use good faith allow Seller to maximize its earnout potential ("Purchaser agrees to act reasonably in good faith to allow [Seller] to have a fair opportunity to qualify for the maximum payments provided for by this [earnout]....").

Intepreting this provision, both the Fourth Circuit and the underlying federal trial court found that the sales revenues should include those from certain follow-on acquisitions. Considering how broad the "any source" language was, this decision is not surprising. The court also acknowledged that while this result may be due to poor drafting, it is not their role to supervene. ("While it is conceivable that the parties' failure to be more explicit concerning Recall's subsequent acquisition revenue was due to poor drafting rather than the actual intent of the parties, it is not the role of the court to speculate or rewrite the terms of the Agreement....")

Vaughn presents a good case study for companies engaged in roll-up strategies, and to their sellers. If follow-on acquisitions, or "tuck-ins" are planned, it is important to expressly carve them out of any earnout provision. Sellers, on the other hand, need to protect themselves from the unknown. If you can get paid in cash and get it upfront, good work. If not, dont assume you will ever get your full earnout. It is probably unrealistic for most sellers to demand consent rights or a buyout of the earnout in the event of follow-on acquisitions. That said, sellers may be wise to insist on a careful segregation of the sold business to facilitate an earnout calculation, and as here, to insist on "good faith" language to encourage the buyer's good behavior.

Delaware court comments on "spring loaded" options

This has been an interesting month for stock option decisions. As mentioned in my prior post, a few weeks ago the Delaware Chancery court took a hard line against backdating option practices in Ryan v. Gifford (now available on the Chancery Court's website here).

Another decision issued on the same day (2/6/07)is In re Tyson Foods, an opinion written by Chancellor Chandler. The relevant part of this case is the discussion on "spring loaded" option grants issued by the Company to favor executives. Ok, so what are "spring loaded" options? The court explains that the are options granted right before a company makes an announcement that is expected to have a positive result on the stock price. The converse of this practice are "bullet dodging" grants, where the grants are timed to take place after the impact of an announcement that is anticipated to depress stock price, thereby giving the benefit of a lower strike price.

This theory of liability is interesting because it is different than straight backdating. As the court points out, backdating has the inherent problem of falsifying information about the grant itself. The date of issuance is false, as is the representation to stockholders that the option was granted at fair market value on its grant date. Spring loading, however, does not necessarily face the same ethical issues. As the court notes, a company may be justified in knowing issuing options that are in the money to executives, as a means to retention and providing performance incentives. The problem lies with disclosure.

The court notes that "[t]he touchstone of disloyalty or bad faith in a spring-loaded option remains deception, not simply the fact that they are (in every real sense) 'in the money' at the time of issue. A board of directors might, in an exercise of good faith business judgment, determine that in the money options are an appropriate form of executive compensation.... A company with a volatile share price, or one that expects that its most explosive growth is behind it, might wish to issue options with an exercise price below current market value in order to encourage a manager to work hard in the future while at the same time providing compensation with a greater present market value. One can imagine circumstances in which such a decision, were it made honestly and disclosed in good faith, would be within the rational exercise of business judgment...."

The interesting common thread between both decisions is the overtone relating to good faith/bad faith by directors. Some commentators have already noted that this arises from the Disney decision from 2006 where the Delaware Supreme Court elaborated on what some see as a new duty by the board, one of good faith. This analysis seems to allow for a private right of action under state law against directors, where theories under federal law for insider trading have not gotten much traction with the courts. (“To act in good faith, a director must act at all times with an honesty of purpose and in the best interests and welfare of the corporation.”)

The court also notes in dictum that a director may be absolved of liability if shareholders have expressly empowered the board of directors (or relevant committee) to use backdating, spring-loading, or bullet-dodging as part of employee compensation, and that such actions would not otherwise violate applicable law. It seems like this language could be useful in drafting future plans, although it begs the question as to what impact it would have under 409A, where you may still run into a problem for issuing options below fair market value.

IRS issues tax reprieve for backdated options

Last week the IRS announced an initiative aimed to relieve for rank-and-file employees (as opposed to company executives) affected by backdated and other mispriced stock options. The announcement can be read here.


An employee who exercised a ‘backdated’ stock option in 2006 may owe an additional 20-percent tax, plus an interest tax, under the Federal tax laws governing deferred compensation. If the option had been properly priced, the employee normally would only have owed income tax on the difference between the value at the date of grant and exercise.
The initiative allows companies to step forward and pay the additional 20-percent tax and any interest tax that employees owe.

Employers and employees must both act quickly. Under this initiative, employers must notify the IRS of their intent to participate by Feb. 28, 2007. The employers, in turn, will be required to contact affected employees by Mar. 15, 2007 to inform them that the employer has applied to participate in the Compliance Resolution Program.

Delaware Chancery Court weighs in on option backdating controversy

This month the Delaware Chancery Court wrote a very strong opinion indicating that its position on option backdating is not likely to be a light one. In Ryan v. Gifford (which may soon be available online for on Delaware’s court site, but for now just on WESTLAW (2007 WL 416162), the Court refused to dismiss a case brought against the Board of Maxim Integrated for backdating options. The decision provides very strong language that suggests that the Delaware courts are going to be very critical of this once-widely accepted practice.

* For example, the opinion provides that backdating options qualifies as one of those “rare cases [in which] a transaction may be so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of director liability therefore exists.”
* In a footnote, the Court reminded that backdating may expose Boards not only to potential civil liability, but also to potential criminal liability for securities fraud, tax fraud, and mail and wire fraud.

While this decision takes place at a juncture of a motion to dismiss, where courts are generally wary to throw out a case when there has not been sufficient opportunity to explore the facts, the tone of this decision is grave. It will be interesting to watch as this and other cases evolve.

What do VCs want from their CEOs

What do VCs really want from their CEOs? A recent study by VentureOne shows that #1 is sales and marketing, followed by operations leadership, financial management and product development.

The study summary can be found here

This study of VCs and CEOs reflects some interesting, but not surprising statistics about board members in startups and tech companies.

• most companies have 4-7 board seats, with 4-5 being the highest out of that range. 5 is a pretty common number, since that avoids a deadlock.

• in about 1/3 of the companies, the VCs hold 20-40% of the seats; in about 1/3, it's 40-60%. Again, a board of 5, 1-2 seats is commonplace.
• conversely, company management holds 20% or less on most boards - 1 seat for the CEO then in office is pretty common. If that CEO is also the founder, and later is displaced from the CEO office, it is common for the founder to remain as the Chairman of the Board.
• As far as compensation for Board membership, it looks like most companies do not compensate their directors in any way, and that a minority does so with stock options. Cash and stock seems to be a more phenomenon, which makes a lot of sense considering how cash dependent most startups tend to be.
• It is a bit surprising to find that both VCs and CEO agreed that the most significant value of a VC boardmember is for help with financings and locating investors. The answer I would have expected from the VCs is their business expertise and strategic vision is their most valuable asset. Sales and marketing experience is valued, albeit in second place.
• Finally, "dilution of investment" is cited as the biggest factor of conflict on a board. This is a good reminder that while your investors are usually aligned with the founder's interests, when it comes investment time, all bets are usually off and its every man (or VC) for him/herself. This is especially true if you have been lucky enough to have had multiple investment rounds (or "series") and have various illustrious investors on your board. Since this is something that most investors fully acknowledge, founders should not be afraid to voice their concerns about potential conflicts and should seek to have at least some disinterested (independent) directors on their board.

Recent Massachusetts case on corporate freezeouts

A recent decision by the Massachusetts Supreme Judicial Court (SJC) found that in a close corporation context, the estate of one of the company’s founders that was a minority shareholder was not entitled to a buyout. See here for the opinion: http://www.socialaw.com/slip.htm?cid=16741&sid=120

The court stated that in a freeze-out situation, the buyout is not the only reasonable remedy. Instead, since the freeze-out denies the minority’s “reasonable expectations of benefit” of being a stockholder, the remedy should, to the extent possible, restore to the minority shareholder those benefits reasonably expected, but not received because of the breach.

The court explained that “in ordering the defendants to purchase the plaintiff’s stock at the price of her pro rata share of the company, the judge created an artificial market for the plaintiff’s minority share of a close corporation — an asset that, by definition, has little or no market value.” This is a very interesting position, considering all of the ado over 409A and stock option valuations for startup companies in the last few years.

Recent Massachusetts case defines defacto merger

A recent Massachusetts appeals court decision defines Mass law regarding defacto mergers and successor liability regarding environmental claims. The case can be found here: http://www.socialaw.com/slip.htm?cid=16545&sid=119

This case summarizes as follows the Mass law regarding defacto mergers:

Factors considered in determining whether a sale should be treated as a de facto merger are: “whether (1) there is a continuation of the enterprise of the seller corporation so that there is a continuity of management, personnel, physical location, assets, and general business operations; whether (2) there is a continuity of shareholders which results from the purchasing corporation paying for the acquired assets with shares of its own stock, this stock ultimately coming to be held by the shareholders of the seller corporation so that they become a constituent part of the purchasing corporation; whether (3) the seller corporation ceases its ordinary business operations, liquidates, and dissolves as soon as legally and practically possible; and whether (4) the purchasing corporation assumes those obligations of the seller ordinarily necessary for the uninterrupted continuation of normal business operations of the seller corporation.” Cargill, Inc. v. Beaver Coal & Oil Co., 424 Mass. 356, 359-360 (1997).

The court noted that one key is looking at continuity of management, employees and shareholders.

This decision is also instructive on the liability a buyer would assume pursuant to express language in a purchase agreement. The court found that buyer’s assumption of liabilities of seller “as then existing” pursuant to an asset purchase agreement was not sufficient to hold that buyer assumed CERCLA liability then unknown.

CEO transitions in life of venture-backed startup

Most startups suffer high staff turnover, and their CXO’s are no exception. In the short but exciting lifespan of a venture backed startup, it is not unusual to see two or more CEOs and other CXOs rotate through the company to navigate it through the rough waters of going from idea to beta to market, and so on.

See the following link for a recent whitepaper that honestly discusses this point: http://www.pwcmoneytree.com/exhibits/RitesOfPassageArticle.pdf

While experienced, or “repeat”, CEOs are less prone to find themselves in this position, most early stage executives may find that the investors want to make a change or bring in a more specialized industry player with execution success. Founder teams that plan to seek investment capital are wise to plan for such a potential change and position themselves in the company where they could have a long-tenured position. Discussing this issue upfront with their investors and negotiating appropriate employment agreements is always a good idea to give both sides the comfort and incentive necessary for promoting the overall success of the business and gaining the investors’ trust.

PWC Moneytree Survey shows increase in VC investments into Media and Entertainment

PWC Moneytree Survey shows increase in VC investments into Media and Entertainment

The PWCMoneyTree Survey for Q4 2006 shows in increase in deals over the last 5 years. VCs invested over $25 billion in 3,416 deals in 2006, a 10 percent increase in deal volume and a 12 percent increase in dollar value. 2006 had significant growth in life sciences, biotech and medical devices, and a strong year for Media/Entertainment, Energy and Web 2.0 companies. In particular, Media and Entertainment companies raised $1.6 billion in 299 deals (compared to 2005 when $1 billion went into180 deals). Telecom raised $2.6 billion, with wireless accounting for 44 percent of the Telecom sector deal size. The study and related links can be found here: http://www.pwcmoneytree.com/moneytree/index.jsp

New England had over 400 deals in 2006 (11% of national deal volume in deal size), second only to Silicon Valley, which had over 1100 deals (35% of national deal volume in deal size).

Another report provides valuation tracking going back to 1997. The average pre-money valuation for “Early Stage” (i.e. Series A) seed level deals for Q3′06 was just over $6M, with a typical seed round around $5.6M. Expansion Stage deals (i.e. Series B or Series C) had an average pre-money valuation of $54M, with an average deal size of $13M. The report can be read here http://www.pwcmoneytree.com/exhibits/Valuations_95_06Q3_12MonthRollingAvgs.xls

Recent Delaware and Maryland cases interpret redemption rights

Today’s VC deals (at least on the east coast) are likely to contain a redemption clause in the charter of the company, giving the investors a “put” right to make the company buy back their investment after some period of time has passed (usually 5 yrs or more). VC funds have their own investors and want to see an exit within the same period, so the redemption right gives some additional (perhaps illusory) protection to the investors that they can cause the company to liquidate their position. Of course, if the company does not have the money, little can be done. The concept really works only when the company is financially stable, but the other stockholders do not want to liqudate their investment or sell (i.e. perhaps it is lifestyle company or there is disagreement on timing), which allows those with the put rights to seek a buyout.
Several recent decisions help interpret the scope of redemption rights in context. In Harbinger Capital Partners v. Granite Broadcasting, the Delaware Chancery Court ruled that preferred stock that was mandatorily redeemable by the company was still equity, not debt. The case can be read here. The preferred stockholders sought to enjoin a sale of assets by the company by claiming that they were a creditor, and the sale a fraudulent conveyance. Their argument was based largely on a recent change in accounting rules under GAAP and FASB that provided for a debt treatment of certain types of preferred stock with redemption features. The court rejected that theory. Relying on a long line of cases, it held that the rights of shareholders to recover dividends or to redeem their stock is dependent on the financial solvency of the corporation,’ and is therefore not a fixed liability.” Marking its territory, the court also noted that FASB was neither lawmaker nor judge,” and should not have “the power to fundamentally alter the law’s understanding of the role of preferred shares.”
Another 2006 case by a Maryland state court had a different take on the issue. In Costa Brava Partnership III v. Telos, (2006 WL 1313985) investors argued that their preferred shares were debt because they “lack voting rights in most circumstances, yield fixed dividend payments, maintain a fixed maturity date, have redemption and liquidation rights which do not exceed the security’s issue price, retain priority over common stockholders, and are classified as “indebtedness” in the corporate charter. “ They also argued that the company itself classified its accruing dividend obligations as debt on its financial statements. The court stated that such conduct by the company would indicate the preferred stock is to be treated as debt. Therefore, without expressly ruling on the issue of whether the investor can be considered a creditor, the court refused to dismiss a claim for fraudulent conveyance (which can only stand if ultimately Costa Brava is found to be a creditor).
Another 2006 Delaware Chancery Court decision, Thoughtworks v. SV Investment Partners (aka Schroeders), provides an interesting introspective on how courts interpret the mechanics of a redemption provision, and perhaps a useful roadmap on how they are negotiated. The case can be read here: http://courts.delaware.gov/opinions/(w0fpgu55x0mqkc45box4kbml)/download.aspx?ID=79250. In typical Delaware court fashion, the court interpreted the redemption language in the charter very strictly and refused the company to delay its redemption payments to fund working capital. The court looked at the history of negotiations, where the Company originally wanted to carve it entire budget out of available funds for redemption but the parties finally agreed on a carveout for a particular year (2005). In light of the Harbinger case I am not sure what of the ultimate impact in this case, when it seems that the company may have trouble making the payment in any event.
Notwithstanding the strict constructionist approach on redemption, the court in Thoughworks took a different tack on interpreting a negative covenant in the charter. The negative covenants did not expressly reference a material indebtedness provision, requiring consent only for any contractual arrangement providing for the payment of $500,000 or more.” The Court found that “such contractual arrangements can be easily read to include debt transactions.” (I am not sure I agree). This finding by the Court is a bit of a surprise, as I think most corporate and vc lawyers would find the language to be lacking.