Delaware Court of Chancery discusses ‘exit rights’ in venture-backed companies

January 2014 | EXPERT BRIEFING | VENTURE CAPITAL

financierworldwide.com

Many venture capital firms employ an investment model that contemplates an exit – whether by IPO, sale, or otherwise – within a set number of years. For myriad reasons, venture capital firms nonetheless often structure their investments as purchases of preferred stock rather than debt. Holders of preferred stock, unlike holders of debt, generally cannot force a liquidity event if the investment is not providing a satisfactory return within a set period of time.

Frequently, the board of a venture-backed company will face a variation of the following hypothetical conundrum. A company is valued at $1m. The company’s preferred stockholders are entitled to receive a liquidation preference of at least $2m upon a sale of the company, with that value increasing at a rate of 8 percent per year. A new product is in the pipeline. That product only has a 10 percent chance of success, but if it does succeed, the value of the company may exceed the value of the preferred stock preference – i.e., the common stock may be above water. A common stockholder’s interest will always be to pursue the product; because the common stock currently is underwater, the common stockholders effectively would be pursuing value using the preferred’s equity. The preferred stockholders (especially if they do not share in value above their preferences), on the other hand, often will favour a quick sale because it offers a higher risk-adjusted return, and eliminates further risk to their investment.

The Delaware Court of Chancery, in In re TRADOS Incorporated Shareholders Litigation, provides useful guidance to directors facing this conundrum. TRADOSinvolved a challenge to SDL plc’s acquisition of TRADOS Incorporated for $60m. Of that $60m, approximately $52.2m went to the preferred stockholders and approximately $7.8m went to participants in a management incentive plan. No consideration was paid to the common stockholders. A seven person board – including two employee directors who received consideration under the management incentive plan, and three directors who were designees of venture capital firms that held preferred stock – approved the sale without forming a special committee and without obtaining a fairness opinion. Although the Court found that the directors did not follow a fair process in approving the sale, it held that, because the common stock had no economic value before the merger, the transaction was entirely fair.

The Court began its analysis by observing that “[e]quity capital, by default, is permanent capital”. By default, then, a decision to facilitate an exit from a venture capital investment is subject to directors’ fiduciary duties. The Court rejected an argument that, when the interests of the common stock and preferred stock diverge, the directors’ fiduciary duties mandate whatever action maximises the value of the enterprise (i.e., to follow the route that offers the highest risk-adjusted return taking into account the interests of all equity holders). Rather, the Court reaffirmed that, when the interests of the common stock and preferred stock diverge, generally it will be the duty of the board to “prefer” the interests of the common stock to those of the preferred. Importantly, however, the Court did not state that, when those interests diverge, it would be the duty of the board to “exploit the preferred” (a duty suggested in a prior Court of Chancery opinion). Thus, for example, the Court did not suggest that the directors had a duty to re-cut the preferences the venture capital firms contracted for when they invested in TRADOS to provide the common with some option value for their stock, nor did the Court suggest that the directors had a duty to alter the business plan to a high-risk “spin of the roulette wheel”. Rather, the Court suggested that the directors had to determine whether the common had any economic value under the then-current business plan. Because the Court found (after applying a discounted cash flow analysis) that the common stock did not have any value under the operative business plan, the Court held the directors did not breach their fiduciary duties by approving a liquidity event resulting in no consideration to the common.

In our view, a key import of this opinion is the above clarification of the directors’ duties when facing a decision involving divergent interests of common stock and preferred. Also noteworthy, however, is the Court’s observation that contracting around the defaults discussed above (i.e., the duty to “prefer” the interests of the common) may “result[] in greater aggregate returns and maximize[] overall societal wealth”. Although dicta (the preferred stockholders in TRADOS did not appear to have any contractual exit rights), this portion of the opinion continues a line of Court of Chancery decisions suggesting methods to facilitate a venture capital exit from a preferred stock investment. Those methods include: (i) drag-along rights (TRADOS; SV Inv. Partners, LLC v. ThoughtWorks, Inc.); (ii) redemption rights (ThoughtWorks); (iii) call options on the company (ThoughtWorks; Hokanson v. Petty); (iv) rights to force liquidation (In re Berkshire Realty Co., Inc.); and (v) (newly suggested in the TRADOS opinion) charter provisions to “realign the directors’ fiduciary duties”. A venture capital firm considering an investment should consider the pros and cons of, and limitations to, each of these exit mechanisms.

Although TRADOS raises new questions just as it resolves others, it is clearly one of the most important cases in recent years providing guidance for – and to a large extent, comfort to –venture-backed companies and their directors.

William M. Lafferty and Eric S. Klinger-Wilensky are partners at Morris, Nichols, Arsht & Tunnell LLP. Mr Lafferty can be contacted on +1 (302) 351 9341 or by email: wlafferty@mnat.com. Mr Klinger-Wilensky can be contacted on +1 (302) 351 9169 or by email: ekwilensky@mnat.com.

William M. Lafferty and Eric S. Klinger-Wilensky

Morris, Nichols, Arsht & Tunnell LLP