The Venture Capital Board Member’s Survival Guide

Steven E. Bochner and Amy L. Simmerman are partners at Wilson Sonsini Goodrich & Rosati. This post is based on their recent article and is part of the Delaware law series; links to other posts in the series are available here. The views expressed in this article are those of the authors and are not necessarily those of Wilson Sonsini Goodrich & Rosati or its clients. Related research from the Program on Corporate Governance includes Carrots & Sticks: How VCs Induce Entrepreneurial Teams to Sell Startups, by Jesse Fried and Brian Broughman (discussed on the Forum here).

The venture capital industry and the companies it supports are a crown jewel of the United States economy. The sector fuels innovation and economic activity and has spawned companies such as Apple, Amazon, Netflix, Cisco, Google, Facebook, Genentech, Tesla, and Twitter.

While there is an alignment of interests among stakeholders in venture-backed companies much of the time, certain recurring features of venture capital investments lead to potential structural conflicts under Delaware corporate law. Venture capital investment terms typically include the right to elect a partner of the fund to the private company’s board of directors. The venture fund directors in this context are “dual fiduciaries,” having fiduciary duties to the fund itself and its partners, as well as to the stockholders of the company on whose board they serve. In addition, venture capital investors obtain, in the form of preferred stock, preferential rights over holders of common stock in areas such as allocation of proceeds in an acquisition of the company, protection from future dilution, and special voting rights. Transactions in which the interests of the preferred and common holders diverge, such as down-round financings and acquisitions resulting in disparate treatment of stockholders, can create difficult conflicts of interest. Over time, the Delaware case law has come to hold that where preferred stock terms address an issue, the rights of preferred stockholders are generally contractual in nature, and directors should, where possible, prefer the interests of common stockholders. This may exacerbate the potentially conflicted position of the venture fund designee whose fund holds preferred stock.

Doctrinally, the well-known, deferential business judgment rule is the default rule under Delaware law. This rule provides that courts should not second-guess the business decisions of directors and that, if stockholders challenge a board’s decision, directors are presumed to have acted in accordance with their fiduciary duties of care and loyalty. This rule is extremely helpful to directors. But where certain types of conflicts exist, the deference of the business judgment rule falls away and courts instead apply the opposite of the business judgment rule: the difficult “entire fairness” standard of review. Under that standard, directors have to prove to a court that the process surrounding a transaction, and the terms of a transaction, were fair to stockholders. As many recent Delaware cases show—including in the venture-backed context—the entire fairness standard is fact-intensive and often leads to protracted litigation.

There are two fundamental, recurring ways in which a conflict triggering the difficult entire fairness standard of review can arise in the context of a venture-backed company. One way is when at least half the board has some kind of conflict in a transaction. This type of conflict could exist, for example, where a director is a principal of a fund or has certain types of longstanding relationships with a fund, and the fund holds preferred stock that fares meaningfully better in a transaction than common stock—or where a director is a member of management who receives a special benefit in a transaction. Under Delaware law, whether a director has a conflict is assessed on a director-by-director basis and is extremely fact-intensive. In the eyes of a court, where at least half of the board has a conflict or a potential conflict, there is not a disinterested decision-maker and the possibility arises that the board has not acted in accordance with the fiduciary duty of loyalty.

The other way a conflict can exist is if a fund, or separate funds connected in some meaningful way, are found to be a controlling stockholder, and the controller (or control group) engages in a transaction with the company or receives a special, discrete benefit in a transaction as compared to stockholders generally. In such a context, courts view the controller or controllers as exerting control over the property of others—the minority stockholders—and taking on fiduciary duties. The existence of control does not depend on the possession of a majority voting stake. For example, in a recent case involving a private company on a motion to dismiss, the Delaware Court of Chancery found that a private equity fund owning less than 27% of a company’s stockholder voting power could possess control.

In the last five years, several litigations in the Delaware Court of Chancery have involved allegations of conflicts in the context of venture-backed companies. These litigations are generally expensive, lengthy, and difficult. They inherently involve allegations of breaches of the duty of loyalty, for which directors and funds potentially face the risk of monetary liability. Directors of venture-backed companies, mindful of this trend and wanting to do the right thing, naturally wonder what they should do.

As an initial matter, there are potentially certain process steps boards can take that could potentially “return” a transaction to business judgment review. These process steps include the possibility of properly using a committee of independent directors and/or obtaining a disinterested vote of stockholders. That said, these process steps can be impractical for a host of reasons, and deploying these mechanisms properly under the case law is not always straightforward. In the context of a financing round, several Delaware cases suggest that opening up the financing to the stockholder base as a whole on equal terms could serve to neutralize conflicts. But again, potential complications exist, both under the Delaware case law and as a practical matter.

Yet even where such process steps are not available, there are many ways in which boards and their advisors can construct a process designed to yield a good result for stockholders and to minimize the risk of exposure in litigation, even if the “entire fairness” standard will apply. The recent case law provides many insights. Directors should understand their fiduciary duties—including that their duties run to all stockholders, especially common stockholders, even if a director is appointed by a particular fund or class or series of stock. Directors should use advisors as appropriate. If a company cannot afford a financial advisor, the record should ideally reflect that. Directors should understand the basis of any valuations that they use and be prepared to explain prior valuations that are no longer accurate. Directors should carefully consider the timing, terms, and negotiations relating to a transaction. Directors should consider and, as appropriate, explore alternatives. Communications with stockholders should be handled properly. Board deliberations should not improperly exclude any directors. Depending on the facts, certain process features may make more or less sense. But these steps are important tools available to essentially all private companies.

The complete article is available here.

Both comments and trackbacks are currently closed.
  • Subscribe or Follow

  • Supported By:

  • Program on Corporate Governance Advisory Board

  • Programs Faculty & Senior Fellows