I am sorry the answers to my event questions have taken this long, but here is my answer to the first question below. I will have my second question and answer up next week. Please remember that this is not legal advice and to read my disclaimer.
How do venture capitalists that sit on the Board of Directors uphold their fiduciary duty to the company when their intentions do not align with the business founders? Short answer is that sometimes they don’t!
For folks not interested in the analysis (which will be brief), I will start by bullet pointing the key take-a-ways regarding director’s conflicts of interest. Here are the relevant points of law and things to consider:
Typically, the “Business Judgment Rule” would apply in director decisions, but where it is clear the decision makers lack independence or have breached a fiduciary duty, then the “entire fairness doctrine” applies. I am referencing these situations.
If most of a board has conflict of interest with respect to a transaction (e.g., financing, merger), then directors could face personal liability and transaction could be sued if a stockholder brings a successful suit.
As a result, it is important to make sure you identify potential conflicts.
Here are a few common fact patterns that lead to conflicts, Watch out for the following:
A director/VC whose fund participates in the “inside round.”
A merger where a director’s fund holds preferred and only preferred stock gets paid out.
A director that is pushing for the sale of a company where the directors fund may have liquidity issues
Directors that have relationships with competitors or funds that fund competitors. Make sure to understand the “Fairness Standard” in application to any transaction. In short, the transaction is the product of both fair dealing and fair price. Not even an honest belief that the transaction was entirely fair will be sufficient to establish entire fairness, but rather, the transaction itself must be objectively fair, independent of the board's beliefs.
I am focusing on transactions where the Business Judgment Rule is rebutted and the Entire Fairness Rule is implicated forcing the defendants (directors with a conflict of interest in the transaction). The interpretation of this rule surprises me because the fairness standard, which usually favors the Plaintiffs, is upheld in situations where it seems clear that common stock shareholders are getting the short end of the stick.
Stated earlier, the Entire Fairness Rule applies when the board is conflicted and the business judgment rule is rebutted placing the burden on the interested directors to show that the transaction is fair to both process and price. This gets tricky because both terms encompass a lot of moving parts. Process includes transaction timing, initiation, structure, negotiations and disclosures. Price includes economic and financial terms, factors intrinsic and /or inherent to the value, and several other valuation metrics that may vary by industry. Without digging to deep, I want folks to understand numerous variables can be argued. Nothing is simple in law!
To highlight one example, the Court in Trados Inc. S'holder Litig., 73 A.3d 17 (case where majority of directors were members of a VC firm that held preferred stock. They voted to pay their preferred stock in a sale leaving the common stock shareholders with nothing) found that the directors did not follow fair process approving a transaction, but the price was found to be fair so the court ruled in favor of the defendants. How is does the court come to this conclusion?
Defendants made a successful argument analogizing the situation to a creditor-shareholder conflict. Arguing that preferred shareholders are likely more conservative because they are more like a creditor. Whereas a common shareholder is willing to roll the dice attempting to turn around an underperforming company. As such, a director affiliated with a VC holding preferred stock with liquidation preference may want to repurpose that investment for more promising holdings in their portfolio. To do that, they would vote to sell the company vs. roll the dice hoping for a turnaround. That is what happened in Trados and the court partially accepted this argument siding with the defendant. The court held this to be an opportunity-cost conflict in corporate law which is a “bedrock economic principle that the cost of a course of action is the highest value alternative forsaken.” Stated otherwise, the cost of something is what you give up to get it.
My point in highlighting just one example is to first, keep this brief because I doubt ten people that are not lawyers will get to this conclusion. Second, this is technical stuff that should highlight the importance of planning to mitigate scenarios that do not favor your position.