Does Trados Matter?

Abraham Cable is Professor of Law at University of California Hastings College of the Law. This post is based on his recent paper, forthcoming in The Journal of Corporation Law. This post is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Agency Costs of Venture Capitalist Control in Startups by Jesse Fried and Mira Ganor.

Delaware courts are producing a growing cannon of corporate law recognizing the distinctive business environment of Silicon Valley. Trados is a prominent example. In a recent paper, I ask Silicon Valley lawyers whether the high-profile case actually affects their advice to clients. The answer? A resounding sort of.

In Trados, the Delaware Chancery Court criticized a board controlled by venture capital funds holding preferred stock. The board approved a merger that, in accordance with customary Silicon Valley stock terms, resulted in a modest payout to investors holding preferred stock but no consideration to common shareholders. Though the court ultimately found in favor of the defendant directors, the court sharply criticized the board’s process and lack of regard for common holders. According to the court, the board “did not understand . . . their job,” “refused to recognize the conflicts they faced,” and engaged in a “vigorous and coordinated effort” to “recharacterize their actions retrospectively.” The only saving grace for the board was their expert witness, who convinced the court that the common stock in fact had no substantial value.

Importantly for connoisseurs of Delaware jurisprudence, the court weighed in on a key conceptual issue: to whom do directors owe their fiduciary duties in the context of common-preferred conflicts? To the corporation, common holders, or preferred holders who negotiate for board control? The Trados court endorsed a rule of common-maximization:

[G]enerally it will be the duty of the board, where discretionary judgment is to be exercised, to prefer the interests of the common stock—as the good faith judgment of the board sees them to be—to the interests created by the special rights, preferences, etc. …. of preferred stock.

The case generated a flurry of law review articles and law firm memos. The law review articles focused largely on the beneficiary question and the court’s endorsement of common-maximization. The law firm memos anticipated changes to customary venture capital contracts to minimize the effects of the case. The influential model forms group of the National Venture Capital Association crafted an elaborate contractual workaround (the “NVCA sale right”). Even in an environment where norms usually loom larger than judicial pronouncements, Trados seemed to catch everyone’s attention.

But how specifically does Trados affect venture capital contracting and board process? I asked 20 startup lawyers who regularly advise startups on financings and exit transactions. While these lawyers may not be the foremost experts on Delaware law—the domain of specialized Delaware counsel and M&A lawyers—they are the primary conduit from court to startup. In practice, Trados means what these lawyers think it means.

From the interviews, a consensus emerges on some points:

  • Trados has not meaningfully affected the terms of venture capital investments. Though one could theoretically mitigate the effects of the case through alterations to traditional drag-along rights or the NVCA sale right, those mechanisms are rarely used. Beyond transaction costs, contractually forcing cooperation of common holders is not practical in a world where the typical common holder (founder or employee) possesses vitally important human capital.
  • Trados has altered board process somewhat. In response to the case, startup boards now more systematically consider the effects of an exit transaction on common holders. Interviewees describe a qualitative process of investigating whether there is any plausible business strategy that would produce returns to common holders. Specifically, boards focus on alternative transactions, the prospects for additional financing, and the ability to retain key personnel. Often this analysis reveals few choices beyond the current offer or dissolution.
  • At the margins, Trados may motivate allocations to common holders beyond their baseline entitlements. In other words, a board that concludes the common has some meaningful potential value (or perceives litigation risk because of a disgruntled common holder) might condition a merger on preferred holders sacrificing some liquidation preference for a modest payout to common holders. But allocations to common have long been observed in Silicon Valley, and it is unclear how much Trados drives them.

On more conceptual matters, the same consensus did not emerge. Interviewees do not agree on whether Trados broke new ground. Some interviewees report that they “always worried” about a claim on Trados-like facts while others report being “surprised” by the decision.

When asked about the beneficiary question, the interviewees balk at any rigid formulation. They doubt a board should imperil company value pursuing long-shot common stock value. Several interviewees offer an indeterminate standard—the board owes duties to all shareholders.

I conclude the article by highlighting a common theme from the interviews—startups do not prioritize Delaware case law to the same extent public companies do. Resource constraints frustrate efforts to procedurally cleanse transactions through independent board committees and other trappings of public company governance. The relatively small amounts usually at stake in Trados fail to motivate much litigation. The startup lawyers who advise startup boards focus more on financing and contracting conventions than Delaware cases.

I suggest that Delaware courts consider these dynamics in their jurisprudence. For example, Delaware courts have emphasized independent board committees and disinterested shareholder votes as ways to steer clear of fairness review, and these safe harbors may allow courts to retain some helpful ambiguity in judicial standards without opening the floodgates for strike suits. But startups may not be well positioned to use these mechanisms. In this environment, Delaware courts should seek to define the parameters of fairness review clearly to stave off questionable claims. In addition, courts should ground their view of procedural fairness in the realities of customary practice in Silicon Valley.

The point of these recommendations is not to endorse lackadaisical startup governance. There may be reasons to subsidize the innovation economy, but lowering the standards for management integrity seems an ill-conceived approach. The point of this analysis is to highlight that ambiguity has a different cost in the distinctive milieu of Silicon Valley, which may justify paying additional attention to the boundaries of emerging caselaw.

The complete paper is available here.

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