Venture capital funds routinely negotiate for a right of redemption – the right to require the company to buy out their shares after a certain period of time if an exit has not occurred – as a key element of their exit strategy. But according to a recent case in Delaware, the VCs and the company‘s board members could be Delaware Court of Chanceryliable to common stockholders if they cause the company to engage in transactions to generate funds for redemption to the detriment of the common stockholders.

Frederick Hsu Living Trust v. ODN Holding Corporation, et. al. involves a $150 million investment by venture capital firm Oak Hill Capital Partners in a holding company formed to own Oversee.net. The investment terms included a right in favor of Oak Hill to demand redemption of its shares for its $150 million investment amount beginning five years after the closing. The following year, the terms of the redemption feature were made more favorable to Oak Hill by imposing on the company a contractual obligation to “take all reasonable actions (as determined by the [company’s] Board of Directors in good faith and consistent with its fiduciary duties)” to raise capital if the funds legally available are insufficient to satisfy the company’s redemption obligation in full.

Not long after its initial investment, Oak Hill bought out one of the company’s founders and gained control over a majority of the company’s voting power and the board. The complaint alleged that, two years later, Oak Hill concluded that exercising its redemption right was the most effective way to achieve the return of its capital, that the company lacked the cash to redeem any shares and that the company should change its business plan from pursuing growth to accumulating cash in order to maximize redemptions. The company then stopped making acquisitions, sold off most of its profitable business lines, changed the management team and approved bonuses that would be payable if the company redeemed at least $75 million of preferred stock. The board subsequently approved and the company executed two redemptions in the aggregate amount of $85 million and paid related bonuses in the amount of approximately $2.4 million. Essentially, the complaint alleged that the directors breached their fiduciary duties by prioritizing the interests of the preferred stockholders over those of the common.

In cases involving directors’ fiduciary duties, courts will generally follow the business judgment rule and give deference to, and not second-guess, directors’ decisions. In cases where the board is not constituted with a majority of disinterested directors or otherwise does not act through a special committee of disinterested directors, however, directors’ actions are examined not by the business judgment rule but by the entire fairness standard, effectively shifting the burden to the defendants to establish both that the process and price were fair. In ODN Holding, none of the directors was deemed to be disinterested, so the focus of the case was on whether or not the process undertaken by the board was fair.

Under Delaware law, board members generally have a legal duty to advance the best interests of the corporation, meaning that they must seek to promote the value of the corporation for the benefit of its stockholders. But in a world of many types of stock and stockholders — record and beneficial holders, long-term holders, short term traders, activists – the question is: which stockholders? In his opinion in ODN Holding, Vice Chancellor Laster stated that a board’s obligation to promote the value of the corporation for the benefit of stockholders runs generally to the common stockholders as the residual claimants, which he said was justified because a corporation has a perpetual life and the common stockholders’ investment is locked in.

In ODN Holding, abandoning a growth strategy and selling off businesses was essentially a zero sum game: the cash generated by the sale of businesses benefited the preferred stockholders because it funded redemptions, but it hurt the common because it left the company without any means to sustain itself. The board chose to benefit the preferred at the expense of the common. But it could have chosen to keep the company intact, redeem preferred shares incrementally over the long run and thus leave open the possibility of creating residual value for the common. That strategy would have been unappealing to the preferred, who clearly wanted their capital returned sooner rather than later.

The court was careful to draw a distinction between preferred stockholders and lender/creditors. Unlike creditors, preferred stockholders have no legal right to fixed payments of interest and no maturity date with the prospect of capital repayment and remedies for default. The court went on to state that a redemption right, even one that has ripened, does not convert a preferred holder into a creditor, and doesn’t give the holder an absolute right to force the corporation to redeem its shares no matter what. That’s because redemption rights are subject to statutory, common law and contractual limitations. As a stockholder in a Delaware corporation, Oak Hill’s rights were subject to the requirements of Section 160 of the Delaware General Corporations Law. As a matter of common law, redemptions cannot be made when the corporation is, or would be rendered, insolvent. By contract, under the terms of the preferred stock itself, redemptions could only be made out of “funds legally available,” and the board only had an obligation to generate funds for redemptions through “reasonable actions” as determined by the board in good faith and consistent with its fiduciary duties.

The opinion states that a board does not owe fiduciary duties to preferred stockholders when considering whether or not to take corporate action that might trigger or circumvent the preferred stockholders’ contractual rights, i.e., redemption rights. Preferred stockholders are owed fiduciary duties only when they do not invoke their special contractual rights and instead rely only on rights shared equally with the common stock.

It should be noted that Oak Hill’s preferred stock did not carry a cumulative dividend, a common feature of preferred stock which would have otherwise steadily increased the amount of the liquidation preference. Had Oak Hill’s preferred stock included cumulative dividends, the board might have stronger grounds to conclude that there was no realistic scenario for the company ever to generate proceeds sufficient to satisfy the preferred’s liquidation preference (as supplemented by the cumulative dividends) and then to have any value left over for the common, in which case the board would have been justified in liquidating the company with all proceeds going to the preferred.

It also bears emphasizing that ODN Holding was decided on a motion to dismiss, a pleading-stage decision, in which the plaintiff is given the benefit of the doubt. The court left open the possibility that the trial court could find that, even without the obligation to pay cumulative dividends, the directors could have reasonably concluded that the company’s value as a going concern would never exceed Oak Hill’s $150 million liquidation preference and so selling substantially all the assets with all proceeds going to the preferred and nothing left for the common was defensible because the common was effectively worthless. But that issue would have to be determined at trial, not on a motion to dismiss.

Key Take-Aways: Companies should tread very carefully in embarking on a series of transactions to generate funds for redemption when the board is not constituted with a majority of disinterested directors. Directors must treat preferred stockholders, even those with ripened redemption rights, differently than creditors, whose contractual rights have far less legal restrictions and whose rights need not be balanced against those of the common stockholders. Where a board contemplates a course of action to benefit the preferred, they must be prepared to prove that doing so was value maximizing because the preferred holders’ liquidation preference exceeded the company’s value as a going concern, effectively rendering the common stock worthless. And finally, from the investors’ perspective, negotiating for and securing cumulative dividends would help bolster that last argument.

exitEvery founder of a growth startup dreams of a big, successful exit — a sale of the company for millions of dollars. But that dream could be shattered if the investors are able to cause the company to be sold prematurely with proceeds only equal to or barely exceeding the investors’ liquidation preferences, leaving little or nothing for the founders. Such a proposed deal will almost always be opposed by the founders, believing that the company could achieve a much higher valuation if it remained independent for a bit longer. Whether or not such a deal gets consummated over the objections of the founders depends on state law provisions and negotiated contractual terms that combined will determine the one factor that ultimately matters: control over the deal process.

Background: Liquidation Preference and Investment Horizon

In a typical round of venture funding, the investors receive a liquidation preference, i.e., the right to receive first dollars (after creditors are paid) up to an agreed amount in any sale of the company. In a company’s first institutional funding round (typically designated as Series A), a liquidation preference of 1X plus annual dividends of 8% is “market”, i.e., the investors get an amount off the top equal to the amount they invested plus accumulated dividends before the common shareholders receive anything. Later rounds (Series B, Series C, etc.) may have liquidation preferences of higher multiples of dollars invested, e.g., 1.5X, 2X, etc. A more investor friendly variation is what’s called participating preferred, in which the investors, after receiving their liquidation preference, then share pro rata in the remaining proceeds with the common shareholders, often up to some maximum amount.

So if a VC is not sanguine about a portfolio company’s long term prospects, he may be happy to sell the company for an amount equal to his liquidation preference, particularly at a point several years into the investment. In this regard, the time horizons of founders and institutional investors are inherently in conflict. A venture fund’s limited partnership agreement will typically limit the fund’s life tomoney vs. time ten years, with the initial three years designated for sourcing investments and the remaining seven for exits. With certain exceptions, a fund manager is required to distribute any profits to the fund’s limited partners by the expiration of that ten-year period, which is why a VC’s investment horizon in any given portfolio company is typically three to seven years. Consequently, a VC will often favor a quick exit because it offers a higher risk-adjusted return, and eliminates further risk to their investment. In other words, the VC might believe there’s some likelihood the company’s valuation may increase, but why risk it if he’s entitled to his liquidation preference, particularly if the wind-down of his fund is imminent? Free of such timing constraints, a founder on the other hand would almost always prefer to buy more time, particularly when the company’s projections show an upward trajectory. The founder’s problem, though, is that acquirors will generally value a company based primarily upon historical data, and will either ignore or heavily discount projected metrics.

State Law

So in a sale of the company proposed by the investors and opposed by the founders, who determines whether the deal gets consummated? The starting point is state law. The corporate statute of the state of the company’s incorporation will dictate the minimum vote threshold needed from shareholders. Some state statutes are more protective of common shareholders (founders almost always hold common shares) by requiring approval of the common holders voting separately as a class, essentially a group veto, and/or may require a supermajority vote, which gives the common the ability to block a deal if they collectively own enough shares to prevent the majority from meeting the vote threshold. States that are less protective of common shareholders will require only approval of a simple majority of holders of all shares outstanding, without requiring a separate class vote. That’s the Delaware model. New York voting rightscorporations organized before 1998 must secure a two-thirds majority of all holders unless their charter provides for a simple majority (simple majority for post-1998 corporations), and a separate class vote is required to approve a merger if the shareholders receive stock of the acquiror or another entity containing attributes not included in the target’s charter for which the target’s shareholders would have been required to approve in a separate class vote under New York law.

Another source of state law that impacts control over the deal process is case law regarding a director’s fiduciary duty. Before a proposed acquisition even gets to a shareholder vote, it must be approved first by a majority of the target company’s board, whose actions must be consistent with the directors’ fiduciary obligations. These include primarily the duty of care (generally, the obligation to be informed and diligent) and the duty of loyalty (essentially, the obligation to put the interests of the company and the shareholders above a director’s personal interests and not have any conflicts). Shareholders have a right to sue directors for breaches of fiduciary duty, and common shareholders will have a stronger or weaker case in attacking approval of the sale of a company as a violation of fiduciary duty depending on how favorable a particular state’s fiduciary duty case law is to the common holders. Delaware fiduciary duty case law is regarded as board friendly.

Contractual Terms

Some of the most important terms negotiated by VCs in a venture investment are the ones impacting control, both at the board level and the shareholder level. As mentioned above, a sale of the company must first be approved by a majority of the directors. The allocation of board seats is determined by negotiation during each round of funding. Although a fair outcome would be for investors to receive board representation in proportion to their share ownership (e.g., two of five seats when owning 40% of the outstanding shares), the investors will often negotiate for and receive disproportionate representation on the board and sometimes even a majority. A typical board composition arrangement might be a five-person board consisting of two directors designated by the investors, two directors selected by the common shareholders and one independent industry expert mutually selected by the common holders and the investors. But if the industry expert is someone with whom the investors have a preexisting relationship, human nature is such that he will view the investors as a source of future opportunities and tend to side with them, thus giving the investors an effective majority.

Other key control rights negotiated for by VCs are so-called protective provisions, which give the investors a veto over major decisions, including a sale of the company. Here, the battle is over what transactions or decisions make the list, and what vote threshold is required within the class of preferred. But a veto is only a right to block, not a right to approve. It doesn’t give the preferred the right to compel the company to consummate a deal opposed by the requisite holders. That’s where drag-along rights come into play.

Drag-along rights give investors the power to require other holders to vote in drag alongfavor of a deal the investors are proposing, sometimes conditioned on board approval. If a sufficient number of shares are so encumbered, the investors can ensure that holders of a requisite percentage of the outstanding shares or close enough to it vote to approve a deal favored by the investors.

So Who Controls the Deal Process?

Putting it all together, investors are more likely to control the deal process if all or at least some of the following are true: the company is incorporated in a state that does not require a class vote of the common to approve a sale of the company, the state has fiduciary duty case law favorable to directors, the investors have an actual or effective majority of the board and the investors control the cap table either outright or through a combination of ownership and drag along rights. In limited cases, the common shareholders will nevertheless be able to negotiate for a share of the proceeds in sub-liquidation preference deals, getting the preferred to relinquish some of the amount they’re otherwise contractually entitled to. Such an outcome is more likely to occur where the investors are able to approve a deal at the board level, but the common shareholders have one or more of the other factors in their favor, such as ownership of enough shares to block the vote or the benefit of common shareholder favorable fiduciary duty state case law. Or sometimes, the VCs just want to sweeten the pot to create the appearance of fairness to preserve a good reputation. But the VCs will rarely just give anything anyway; they’ll likely condition any common shareholder liquidation preference carveout on the recipients signing a release.