Secrets of Sand Hill Road

by Scott Kupor

  We talked earlier about the opportunity costs of a VC making an investment. Among the reasons for this are that a VC can only sit on so many boards, so every time she fills up a slot on her dance card, she necessarily reduces her availability to invest in other companies. Another form of opportunity cost comes from conflicts: as a VC you can’t really invest in Facebook and Friendster or Lyft and Uber. Rather, the decision to invest in a company likely means that you are conflicted out of other companies that are directly competitive. To be clear, there is no prohibition against this, but the convention of the business makes this hard to do—as a VC you are lending your name and your firm’s brand to your investments, so it’s hard to invest in direct competitors without creating challenges for both companies in the marketplace.

  Where this gets difficult—and the reason I am raising this in the context of the duty of confidentiality—is when companies pivot. It’s pretty easy at the time of an investment to know if the company you are proposing to invest in is competing directly with some other company; thus, navigating the potential conflict at time of investment is manageable. But we know that startups pivot all the time. Some pivots are small tweaks, but others could result in the company entering into entirely new businesses, the result of which may bring them into conflict with another investment that is already in a VC’s portfolio.

  We at Andreessen Horowitz dealt with this early in our firm’s history. We initially invested in the seed round of Mixed Media Labs in 2010. Founded by Dalton Caldwell, Mixed Media was building a mobile phone photo-sharing application. As I mentioned earlier in the book, we also invested in the seed round of Burbn, which at the time was building a mobile location-sharing application (similar to Foursquare). Thus, at the time of our initial investments, there was no conflict. Burbn later pivoted into the photo-sharing space, ultimately becoming the very successful Instagram that was acquired by Facebook for $1 billion in 2012.

  When Burbn and Mixed Media Labs both later decided to raise A rounds, this conflict was apparent. We were not on the board of either company, so this did not create any fiduciary questions regarding the duty of loyalty, but it did raise the broader conflict question we’ve been talking about. We ultimately invested in Mixed Media as part of its A round (and another VC went on to lead the Burbn A round), deciding that the best way to honor the conflict was to give the tie to the company that had started originally in the photo-sharing space versus the one that had pivoted into the space. This was not an easy decision given our respect for both companies—and, to be clear, we had no formal investment restrictions to constrain our behavior—but this is how we ultimately resolved the conflict.

  Where these situations get more difficult, however, is when VC firms have existing investments and board seats in companies that ultimately pivot into another existing investment. Then the duty of confidentiality does come into play, requiring that the firm take various steps to ensure that the board members can satisfy their legal obligations.

  The most common way to handle this situation is to create what’s known as a Chinese wall between the GPs who sit on these competing boards (let’s take the case for now where there are different GPs involved). A Chinese wall is basically a formalistic way to restrict information flow between parties. In this situation, any material information that one GP learns in the context of her board service will not get shared with the other GP. By cordoning off the flow of information, the individual GPs can generally satisfy their duties of confidentiality.

  In the case where a single GP holds both board seats, there are a few options. If the GP wishes to retain both seats (and the companies are both in agreement), then disclosure of the conflict and recusal are the primary mechanisms to manage this situation. Thus, in a board meeting where material areas of conflict arise, the GP would make sure the other board members know of the potential conflict, and she would often recuse herself from that portion of the meeting.

  The more directly competitive the companies are, the harder this becomes, as more and more aspects of the board meeting may give rise to potential conflicts. Thus, in such a situation, it may ultimately require that the GP reassign the board seat to another partner in the firm, enabling them to utilize the Chinese wall process to ensure protection of confidential information.

  Duty of Candor

  The duty of candor requires that board members disclose to shareholders all the requisite information they need to be informed on important corporate actions. For example, if the company is undertaking an acquisition, the duty of candor would require providing the shareholders all the relevant information on the deal: how it came to pass, why the board thinks it’s in the best interest of the shareholders, what the economic terms look like, etc.

  What you’ll find as you sit on boards is that the duties of care and loyalty are really the heart of the fiduciary duties that tend to come into play. It’s not that the other two are not important, but just that if startup company boards get themselves into trouble—or at least need to think about their fiduciary duties in greater detail—it will in most cases implicate the duties of care and loyalty.

  Common versus Preferred Stock

  If you were paying careful attention, you might have noticed that when talking about duties of the board, we’ve been referencing common stock only. That is, we’ve said that the primary fiduciary duty of a board member is to optimize for what is in the best long-term interests of the common shareholders. But what about all the preferred stock shareholders that exist in our typical venture-backed startup?

  Well, it turns out that board members do not owe fiduciary duties to the preferred stock. Instead, the courts have long said that preferred rights are purely contractual in nature; that is, they are negotiated by the parties to the financing agreement at the time of the funding. And—probably most important—they are negotiated by sophisticated parties who can take care of themselves. After all, nobody should have to worry about protecting the big bad VCs.

  So a preferred shareholder could in fact sue if she felt as though the contractual rights that she had negotiated for were being violated—i.e., she had a protective provision vote that the company ignored in undertaking a corporate action. But she could not sue (or, more correctly, she could sue but would lose) alleging that the directors violated their fiduciary duties to her, because in fact none are owed.

  And that really is the fundamental issue behind the difference between how boards need to treat common and preferred shareholders. The basic assumption is that the preferred can look out for themselves, but that there really is no way for the common to do so. Thus, we need to impose fiduciary duties on the board members to protect the little people—those are the common shareholders. As a result, if you find yourself in a sticky situation and are trying to figure out how to weigh things in the balance, you’ll want to honor the contractual rights that the preferred has, but you need to make sure that you are keeping the best interests of the common paramount. Sometimes easier said than done.

  The Business Judgment Rule (BJR)

  Now that we’re familiar with the duties board members owe, the question is, how do we know if we are in fact satisfying them and thus keeping ourselves out of trouble? Enter the business judgment rule, or BJR.

  As a general policy matter, we want people to sit on boards. We’ve decided as a society that people being willing to spend some of their time as board members helps improve the prospects of maximizing the long-term value of the common shareholders. And if every time somebody on a board made a decision they feared that they might be held personally liable for, it’s likely that people would no longer want to sit on boards. We’ve also decided that it’s really hard for courts to second-guess decisions that a board makes after the fact, since they might not have a full appreciation of all the considerations that were factored into the board’s decision-making process.

  As a result, directors are generally entitled to a pretty lax standard of revie
w known as the business judgment rule. In simple terms, the BJR says that the courts are loath to second-guess a board decision as long as, at the time the decision was made, the board acted on an informed basis, in good faith, and with the honest belief that the action taken was in the best interest of the corporation and its common shareholders.

  Importantly, the decision need not have ultimately been right. Rather, the courts will look to evaluate the process of the decision-making to ensure that it complies with the duty of care: Did the directors inform themselves of the facts, did they read the board materials, did they take the time at a board meeting to discuss the issue? Essentially, was there a clear record of an informed, deliberative process? That’s it; if you did that, then you can get the outcome wrong and still be protected from legal liability.

  In fact, it’s even a bit more favorable than that to the board members. In legal terms, the board members are presumed to have done these things. This means that it is up to the plaintiff (the person who is challenging the board’s decision) to prove other-wise; she has the burden of proof to convince the court that the process was bad and thus led to a bad decision. This is a pretty high hurdle to jump and the reason why boards really want to stay within the protections of the BJR; it’s a good comfort blanket in which to wrap yourself.

  How do you do this?

  Well, of course, the first thing to do is to in fact follow a good process. But the other critical item is to make sure that you keep good minutes of the meetings to reflect the frequency and level of deliberations. That doesn’t mean you have to capture every word that is said in the meeting—and good lawyers know how to do this well—but it does mean that you want enough in the record so that if you ever have to defend yourself against a fiduciary duty claim, the record will support your good process.

  This is why you always start the next board meeting by approving the minutes from the prior board meeting. That is your chance to make sure the record is accurate and to be able to show a court later on that you followed a good process in discussing the issues, recording them, and ultimately approving that the minutes accurately reflect what transpired.

  Entire Fairness

  Given how pro–board member the BJR is, do we even need to worry about all this fiduciary duty stuff? After all, it doesn’t sound as though there really is much room for board members to be held personally liable as long as they don’t sleepwalk through board meetings.

  This is where the duty of loyalty comes into play. It turns out that there is a way to get outside of the BJR cocoon: show (or at least allege at the outset) that the board of directors violated its duty of loyalty, putting its own interests ahead of the common shareholders.

  How do you do that?

  There are a number of ways, of course, the most obvious being to show that there was in fact fraud or some egregious self-dealing. But, while that can certainly exist, it’s pretty rare and also often pretty tough to prove.

  The easier way to do this is to show that a majority of the board members were conflicted in some manner (e.g., dual fiduciaries), and that conflict led them to enjoy a financial benefit from the transaction (e.g., an acquisition or a financing) that was not equally shared by the common shareholders.

  We’re going to go through a live example of this shortly to understand the nuances in more detail, but essentially what this does is change the burden of proof in the case and give the court more latitude to look into the details of the business transaction. If you read the legal cases in this area, you’ll see that the courts are basically willing to substitute their own judgment for that of the board if they conclude that there really were not disinterested, qualified decision-makers on the board faithfully representing the common shareholders.

  In doing so, the courts abandon the BJR and move to a new rule called “entire fairness.” There are a couple of important facets of the entire fairness standard.

  First, as mentioned above, the burden of proof changes. That means that, unlike in BJR, where the board members were presumed to be acting with good process and the plaintiff bore the burden to overcome that presumption, in entire fairness the board members don’t get any such presumption. In fact, the directors bear the burden to prove that they were acting in the company’s best interest. I realize for some of you that might not seem like a big deal, but when it comes to defending yourself in court, having the burden to prove your case is much more difficult than coming in with a presumption of fair dealing.

  Second, the courts will now dive much deeper into the decision-making process and analyze two specific aspects of the deal.

  They will first test the fairness of the process itself, asking all the same questions about the board’s deliberations that they would ask in the business judgment rule context, but again this time with the board members themselves having to provide affirmative proof to the court that their process was good. The courts will next test the fairness of the price achieved by the board (in the venture case, that is often the price of the acquisition or of a financing round).

  So entire fairness means that the board members need to prove two things: (1) the process was fair and (2) the price was fair (which really means what the common shareholder got from the deal).

  Finally, I mentioned this before, but this would be a good time to repeat it. A huge difference between violations of the duty of care versus violations of the duty of loyalty is that directors can’t indemnify themselves against breaches of duty of loyalty. So if you lose a duty of care case, that’s certainly no fun, but at least you won’t have personal liability for the ultimate damages. Not so with violations of duties of loyalty; losing may mean digging into your own pocket for real dollars and cents.

  In Re Trados

  To see how this plays out in practice, let’s turn to the seminal Delaware case that covers the fiduciary duty topics in the context of an acquisition. Recall that I mentioned there aren’t many VC cases out there, so this one is pretty important.

  Trados, like most VC tales, starts off with a promising startup. Trados successfully raises multiple rounds of venture financing from very well-respected firms. In fact, Trados raised a total of $57.9 million over its lifetime and, for a while, seemed to be making good progress. Unfortunately, things start to go sideways about five years into its life cycle, and the board decides to sell the company. The board ultimately accepts a $60 million acquisition offer.

  In connection with the venture money Trados raised over the years, it accumulated liquidation preference equal to the $57.9 million in capital it had raised. The liquidation preference was 1x, nonparticipating—recall that means that the investors have a choice to take their liquidation preference off the top, or convert into common shares and take the amount reflecting their ownership, but not both. In the case of the $60 million acquisition offer, all the venture investors were better off taking their 1x liquidation preference, and that is what they elected to do.

  Now, had things stopped right there, it’s possible that this case never would have been brought, and we would be deprived of the ability to read about it. The VCs could have taken their $57.9 million in liquidation preference, and the remaining $2.1 million would have gone to the common shareholders. That’s definitely not a great outcome for common, but maybe the common shareholders would have decided not to fight about this. In fact, they’d probably have had a hard time finding a lawyer who would be willing to take on their case, as the likelihood of winning was pretty remote.

  Whither the MIP?

  However, there’s another important fact to add to the story.

  Once the board decided to pursue a sale of the company, they instituted a management incentive plan, or MIP. Think of a MIP as essentially a carve out from the acquisition proceeds designed to incent the management team to work diligently toward an acquisition. In this case—and in most cases where you put a MIP in place—the board probably had a pretty good idea that the acquisition
offers would not be sufficiently attractive to pay back the liquidation preference and leave much left over for the common shareholders (and, importantly, the employees of the company whom the board wanted to incent to try to sell the company).

  So the board put in place the MIP—the precise amount was based on some percentage of the deal and varied by size of the acquisition. At the $60 million acquisition offer, the MIP paid out $7.8 million to identified employees of the company, heavily weighted toward a few senior executives.

  In essence, the VCs agreed to carve out that money in part from their liquidation preference. As a result, the $60 million in acquisition proceeds were ultimately distributed as follows: $52.2 million to the VCs (less than the $57.9 million that they were entitled to under their liquidation preference), $7.8 million to the MIP participants, and zero to the rest of common.

  A 5 percent owner of common stock, who was dismayed to learn that his ownership stake was now worthless, sued the company and the board, claiming that the deal was not fair. The board, after all, owes fiduciary duties to the common shareholders and, in this case, the plaintiff alleged that the fact that common received nothing from the deal while the investors and participants in the MIP got the benefit of the $60 million proved that something was fishy.

  Conflicted Board?

  The initial question that the court had to resolve in Trados is which standard of review—the business judgment rule or the entire fairness standard—applied. Recall that we talked about the importance of this because it determines which party carries the burden of proof: if the business judgment rule applies, the plaintiff has to prove the unfairness of the process, but if entire fairness applies, the defendants (in this case the VCs and the company’s officers) have the burden of proof.