Secrets of Sand Hill Road

by Scott Kupor

  To determine if the board faced actual conflicts that caused it not to be disinterested and independent, the court does an exercise of counting the heads on the board. In essence, the court goes through the individual board members to determine whether or not each is independent. If a majority of the board is not disinterested, then the board itself is conflicted and entire fairness applies. In the Trados case, the board has seven directors, so if at least four are not independent, the problem is solved. Let’s look closely at this, since it is really the key takeaway for anyone sitting on a venture-financed company board.

  First, the VCs: it turns out that three of the directors represent VC firms that are part of the $57.9 million in liquidation preference. This is not surprising at all, as the company had gone through several rounds of financing, so it wouldn’t have been unusual for the lead investor in each round to ask for a board seat. But the court comes down pretty hard on the VCs.

  The court says that they are conflicted for two reasons.

  Because they have a liquidation preference, the VCs’ cash flow rights cause them to diverge from the common shareholders. You know this by now, having read this book (and thought about the payoff matrices), but the court says it explicitly: the VCs gain less from increases in the value of the company than they suffer from decreases in the value of the company as a result of the liquidation preference.

  Does that make sense? It means that if the acquirer paid $45 million (instead of $60 million), the preferred would lose a dollar of proceeds for every dollar decrease in the purchase price; the VCs would feel that in their pocketbooks. But, if the acquirer paid $75 million for the company, because the VCs were still well underwater relative to the valuations at which they originally invested, they wouldn’t have converted to common and thus still would have received their liquidation preference only. Thus, they were not very incented to argue with the acquirer for a marginally higher price because it provided no economic benefit to them.

  However, that was not the case for the common shareholders. For every incremental dollar of acquisition price, the common shareholder would have received a corresponding dollar increase in their payback. This is because once the VCs elect to receive their liquidation preference as nonparticipating preferred shareholders, they do not participate in any additional upside. Rather, all those proceeds flow to the common shareholders.

  The court also finds the VCs conflicted because of what the court calls the VC opportunity cost model. That is, the court says VCs don’t like to spend time on losing companies (because of the economic trade-offs noted earlier in this book), preferring to spend it on companies that could have real potential economic upside to their funds (and thus improve their at-bats-per-home-run average). As a result, they are motivated in cases like Trados to get as much of their liquidation preference back as quickly as possible, but then not to spend more time pushing up the price. Doing so doesn’t benefit them much, and spending the time has a high opportunity cost of time not spent on winning companies.

  Unfortunately for the VCs in this case, there are some not-so-choice quotes in the record from one of the VCs that made it much easier for the court to find them conflicted. One particular VC stopped trying to spend any time with the company other than to show up for the acquisition-related board calls, told the CEO to get the M&A deal done quickly, and explicitly said that he’d rather be spending time on other potential upside companies. None of that is probably surprising, but note to self: you probably don’t want that kind of stuff in the legal record when trying to defend yourself in court.

  Let’s pause for a second to digest this.

  A ton of lawyers and legal practitioners have tried to ascertain what all this means, but I think the conservative reading of the case says that, if you are a VC board member who has liquidation preference (i.e., basically every VC) and you are selling the company for a price that is way out of the money (i.e., you are not going to convert into common, but instead take your liquidation preference), you should probably assume that you are conflicted. You may be able to make a bunch of arguments to show otherwise, but you don’t want to be doing that in a courtroom after the deal has been closed. Rather, you’ll want to make sure that you do all the right things while you are a sitting board member to increase the likelihood of keeping yourself clean.

  Okay, we’re not off to a very good start here, as we are three for three board members conflicted right out of the gate.

  Let’s look at the two people representing the common shareholders—the CEO and the president. The CEO received $2.3 million from the MIP, and the president received $1 million. So, at first blush, the court says they are potentially conflicted in that they received something from the acquisition that was not available to the other common shareholders. But, the court says, the real question is whether those benefits were material; getting them by itself doesn’t automatically conflict them.

  And how do we figure out materiality?

  The court does a simple economic analysis. For the CEO, it turns out that the MIP payment represented about 20–50 percent of his net worth and was ten times the compensation he had been receiving in his CEO role. Those were sufficient to deem them material. For the president, the MIP payment represented about the same percentage of his net worth as was the case with the CEO, plus he was getting a job at the acquiring company that was very material to him. So the court said it was reasonable to think that his support of the deal could have been influenced by these material benefits.

  Now we are five for five. The court could have stopped here (since we only needed to find four to get to a majority), but why stop when you are having fun? So we now look to the two independent directors.

  What could possibly not be independent about the independent directors? Well, it turns out that one of the independents had a longtime relationship with one of the VCs who was on the board, having been an investor in the VC’s fund (including the one that had Trados in its portfolio) as well as a CEO of two of the firm’s portfolio companies. This independent director had also received shares in Trados through an acquisition of another company in which he was an investor, as was one of the conflicted VCs. The court looked at all this and concluded that all the relationships created a sense of owingness to this VC that could have compromised the independent director’s independence. By the way, the plaintiff didn’t bother challenging the independence of the second independent, so we did in fact have one out of seven that was truly independent.

  We’ve talked about the takeaways here with respect to the VC directors, but we now have some more guidelines to follow stemming from this case.

  First, if you have executives who are representing the common shareholders on the board and they get benefits from the deal that are material to them (e.g., as a percentage of their net worth) and not otherwise shared with the rest of the common, there is a pretty good presumption that they are conflicted.

  Second, calling someone an independent doesn’t make them so. Putting a buddy on the board who owes his career and well-being to you as an investor, portfolio company CEO, or serial board member can create conflicts. Of course, all these things are very fact specific, but you’re now on notice that you need to do this factual analysis at the time you are thinking about a transaction to make sure you don’t have a conflicted board.

  Applying Entire Fairness

  With the court having concluded that the board was indeed conflicted, the deference normally afforded the board under the business judgment rule no longer applied. So the court used the entire fairness standard to review the case. Recall that there are two elements to entire fairness: (1) fair process and (2) fair price.

  On fair process, the court basically throws the book at the board. There are too many things to go through them all, but here are a few that the court noted.

  First, the VCs were too interested in getting their money out versus trying to balance this with the interests of
common. Examples of this that the court cited included that (1) the VCs were very involved in hiring and managing the bankers on the deal; (2) they kept the president on a short leash with respect to operational decisions in the company to maximize the M&A prospects; and (3) they rejected the CEO’s financing proposals and purportedly brought him in just to sell the company.

  Second, the court also objected to the handling of the MIP. Among other things, the court said that boards need to be very careful when the presence of the MIP itself takes away money from the common. Recall in this case that, without the MIP, common would have received $2.1 million—not much, but better than the zero they received. But, because the MIP essentially took common from something to nothing, the court got excited. In fact, the court noted that common contributed 100 percent of its proceeds ($2.1 million) to fund the MIP, whereas the preferred contributed only 10 percent of its proceeds (reducing its take from $57.9 million to $52.5 million). The court didn’t give us a bright-line rule here, but it did say that the board should have considered whether there was a more equitable way to fund the MIP.

  And, finally, there were lots of other elements of the process that the court said evidenced a lack of fair dealing. For example, there was testimony from the board members themselves that they never really considered the interests of the common shareholders, and there was nothing in the official minutes of the board meetings to counter that assertion. The court also objected to elements of the voting process. In particular, the court noted that the president’s participation in the MIP was increased (from 12 to 14 percent of the proceeds) during the course of the deal negotiations, and it appeared that this increase influenced his willingness to vote in favor of the deal. Maybe it wasn’t a pure quid pro quo, but it looked and smelled a bit like it.

  So we’re down to the last piece—the only way to save the defendants is if the court determines that the price common received was fair. In other words, was the common in fact worth more than zero?

  At the risk of spoiling the punch line, this is the part of the case that takes many people by surprise. If you actually read the full opinion and have gotten up to the point of the court’s beginning to review the fairness of the price, you would have given 100 to 1 odds that the defendants are going to get crushed. Everything in this case up until this point feels as though the VCs in particular are going to have to come out of pocket and pay some of their winnings back to the common.

  And then the clouds part and the sun starts shining again—for the VCs, that is.

  We won’t go through the full analysis, but the court reviews a bunch of expert testimony (each side of course has their own expert to testify about the value of the company) and ultimately concludes that the common got exactly what they deserved. That is, the company was pretty much worth zero before the acquisition, so the common got exactly what it was owed.

  Here’s the reasoning: Trados could not secure any additional funding (and the court reiterates the general proposition that the VCs have no obligation to put good money in after bad if they don’t feel like doing so), thus it had no chance to be able to execute on its business plan. In the absence of being able to execute on the plan, Trados “did not have a realistic chance of generating a sufficient return to escape the gravitational pull of the large liquidation preference . . .”

  Saved by the bell! After taking a pretty good tongue-lashing for the first three-quarters of the court’s opinion, the defendants emerge victorious.

  Now, before you start celebrating (depending on where your sympathies lie), everybody spent a ton of time and money on legal fees on this case, so there were real costs, notwithstanding the somewhat Pyrrhic victory for the defendants. And you as an entrepreneur or a VC don’t want to hang your hat on the fair price part of this analysis; if you get to that point, the chances are pretty good that any given court on any given day could come to a different conclusion.

  Trados Takeaways for the Rest of Us

  So, what should you take away from Trados to help you best navigate the boardroom dynamics, particularly in a ho-hum acquisition scenario?

  It’s probably a good starting assumption that most VC-backed startups do not have independent boards. The VCs (preferred) are likely conflicted by virtue of their liquidation preference and, if the common board members have material participation in a MIP, they, too, may be conflicted. And even independents may not in fact be independent.

  If you find yourself in that situation, you’re probably best to assume therefore that the entire fairness test is going to be applied to your situation. If so, you need to really pay careful attention to demonstrating a fair process and/or a fair price. As we’ll mention in a minute, it’s probably easier to get to a fair process than to rely on getting to a fair price.

  Given that, how do you ensure a good process? Here’s a laundry list of things to consider—not all might be relevant for your situation, but the more you can incorporate, the better:

  Hire bankers. Often, hiring a banker is a good way to run a comprehensive process of soliciting bids from multiple parties, understanding of course that sometimes it’s not economically efficient to do so. If you can’t do so, at least make sure that the company directly reaches out to a number of parties as part of the acquisition process. The other role of a banker (which really goes more to the fair price prong of the test) is to have a banker issue a fairness opinion. This is a financial analysis the banker presents to the board at the time of the deal opining that the financial terms of the transaction are within a band of reasonable prices. Utilizing a third party to do this (versus the board itself) is an important protectant for the board.

  MIPs are often good tools to incent management, so we shouldn’t conclude from Trados that you should avoid them. But if you do implement a MIP, be careful about making changes to it too close in time to the decision to vote on a pending deal. In the Trados case, the fact that the president might have received an increase in his MIP participation in order to vote for the deal raised a lot of concerns on the part of the court. The other thing to think about is the relative contribution to the MIP of common versus preferred. Again, recall in Trados that the court didn’t like the fact that the common funded 100 percent of its proceeds into the MIP, whereas the VCs funded only 10 percent. There is no magic number here, but a better allocation (and in particular a discussion of this in the minutes) would have gone a long way toward helping make the process look better. If the VCs had carved out an additional $2 million from their proceeds (the amount that common would have received but for the MIP) to give to common, I suspect the case may have been much easier to decide in their favor.

  Sometimes boards try to set up special committees to wall off conflicted board members and to give special consideration to the interests of common shareholders. As a practical matter, this is tough in many venture-backed company boards just given the likely conflicted nature of a number of the board directors. But where you have the ability to do this, special committees can provide great insulation from charges of self-dealing.

  Another procedural mechanism to protect the board is to implement a separate vote of the disinterested common shareholders. Recall that in most cases, a majority vote of the common and a separate vote of the preferred are often sufficient to approve a deal. But voluntarily adding a separate vote of the most disenfranchised set of shareholders—the disinterested common—is a good way to ensure that they are comfortable with the transaction. Again, this can sometimes be hard to implement in practice, but worth considering nonetheless.

  Although this may sound counterintuitive, often you want to be careful not to have the board members too overreaching in their engagement with the company around the acquisition. If you recall in Trados, one of the VCs selected the banker and was reportedly keeping the president on a short leash to make sure he was unilaterally pursuing the acquisition alternative. While this may have been helpful in getti
ng to the outcome, too much entanglement can be viewed by the court as the board member’s failing to consider the full range of potential options available to the company.

  Most importantly—and really most simply—you need to demonstrate that the board understands the potential for conflicts, is taking the time to talk about them and their implications for common shareholders, and is looking for ways to mitigate the conflicts. The easiest way to start this is to have the company’s lawyers come to a board meeting and basically walk the board through its fiduciary duties (or you could just assign all your board members to read this book). Once you do so, document it in the minutes so it’s in the permanent record as having occurred. When you have board meetings, make sure you also talk about the common shareholders and what, if anything, you are doing to help them. At a minimum you need to show that you are not ignorant of the potential conflicts, even if you can’t find ways to resolve them to your complete satisfaction.

  CHAPTER 14

  Difficult Financings: When Bad Things Happen to Good People

  We spent a bunch of time in chapter 13 talking about the role of the board and its fiduciary duties surrounding an acquisition that reflected a very mediocre outcome for the company. While we of course hope that all startups can continue to raise capital at prices higher than they raised previously, sadly that is not always the case. Sorry to continue the buzzkill theme for a little while longer.

  In this chapter, we are going to spend some time reviewing how to navigate difficult financings. As it turns out, the same fiduciary duty principles that we talked about in the acquisition context apply to the famously dreaded down-round financings.

  As noted previously, a down round is what happens when a company raises funds at a lower valuation than the previous round. By the way, there are lots of flavors of down rounds. Sometimes we have a new investor who comes in to lead a round that is normal in most respects other than that the valuation is lower than the previous round. Other times we have a down round that is led by the existing investors in the company—and, as we’ll talk about, this raises a lot of the core fiduciary duty questions from before.