I’m often asked by clients whether startups should have a separate stockholders’ agreement among the founders. The answer largely depends on whether they have or will have certain other startup documents in place.
First, some background on stockholders’ agreements. These are contracts entered into by owners of privately held companies to manage the following governance
Process still matters. That’s the main takeaway from the Delaware Court of Chancery’s 200-page opinion striking down Tesla’s 2018 incentive package awarded to Elon Musk. The court rescinded the incentive package mainly because Musk was found to control Tesla and the process, the directors authorizing the package were not independent and the stockholder vote approving it was not properly informed. The ruling is a stark reminder of the importance of both director independence and an informed stockholder vote when transacting with a control stockholder.
The 2018 Stock Option Grant
In 2018, the Tesla board approved a new stock option package for Elon Musk and then submitted the proposal for stockholder approval. At a special meeting of stockholders, 81% of the shares voted in favor (or 73% without counting Musk’s and his brother’s shares). If exercised in full, the option package would have allowed Musk to purchase a number of shares constituting 12% of Tesla’s outstanding stock, subject to both milestone and leadership-based vesting. The options vested in 12 tranches, with each tranche vesting on Tesla achieving one capitalization milestone and one operational milestone, and only if Musk continued serving as either CEO or both executive chairman and chief product officer at each vesting juncture. In the most optimistic case, if Tesla’s capitalization grew from $59 billion at the time of the grant in 2018 to $650 billion by 2028 (the option expiration), all the options would vest and be worth approximately $56 billion. As things turned out, Tesla’s market cap did hit $650 billion by the end of 2020 and all the options vested in full.
Was Musk a Controlling Stockholder?
Normally, corporate boards may compensate their executives however lavishly as they wish because Delaware courts will show tremendous deference to board decisions under the business judgment rule and not second guess them. The exception to the general rule is when the compensation is being paid to a controlling stockholder, in which case the compensation or transaction is evaluated under the stricter entire fairness standard which demands a fair price and fair process. The threshold issue then is whether Elon Musk was a controlling stockholder at the time of the 2018 grant.
Control can be established either through mathematical voting control or effective operational control. On the surface, Musk’s 22% ownership stake at the time of the 2018 grant did not constitute mathematical voting control. But perhaps it did when combined with Tesla’s supermajority vote requirement for any amendment to its bylaws governing stockholder meetings, directors, indemnification rights and the supermajority vote requirement itself. The court’s main focus, however, was on Musk’s “outsized influence” over Tesla’s business affairs in general and over the compensation package in particular.
As to general control, the court found Musk exerted significant influence over Tesla’s board, and that as founder, CEO and chairman he “occupied the most powerful trifecta of roles”. Musk also frequently exercised managerial authority over all aspects of Tesla, in many cases ignoring the Board’s authority such as when he appointed himself Tesla’s “Technoking”, disclosed in a Form 8-K, without consulting the Board. The Court was also swayed by Musk’s “Superstar CEO” status, which it said resulted in shifting the balance of power toward himself and away from the board, which was supposed to exercise authority over him.
The court also found Musk exerted transaction-specific control. He almost unilaterally controlled the timing of the grant. There was no negotiation between Musk and the Board over the size of the grant, and no meaningful negotiation over the other terms. Neither the compensation committee nor the board engaged in any benchmarking analysis. Directors testified at the trial that they viewed the process as “cooperation”, not a negotiation.
Musk’s controlling stockholder status meant that the applicable standard of review would be the entire fairness standard. As a procedural matter, the defendants have the burden of proving fair price and fair process. But defendants (in this case, Musk, the other directors and Tesla) can shift the burden to the plaintiff if the transaction was approved by either a well-functioning committee of independent directors, or an informed vote of the majority of the minority stockholders. As a practical matter, burden of proof in these cases is determinative; the party with the burden almost always loses.Continue Reading Out of Control! What the Elon Musk Compensation Case Reminds Us about Transactions with Controlling Stockholders
Starting January 1, 2024, virtually all private companies will be required to report information about their beneficial owners to the Treasury Department’s Financial Crimes Enforcement Network “FinCEN”) under the Corporate Transparency Act (the “CTA”). But the CTA presents unique analytical and reporting challenges for startups and venture backed companies because of the special economic and governance rights negotiated with investors in early stage and venture funding rounds.Continue Reading Corporate Transparency Act Risks for Startups and Venture-Backed Companies
The collapse of Silicon Valley Bank will have enormous repercussions for startups and VCs in ways seen and unseen. As for the unseen, SVB had deep relationships among the various players in the venture ecosystem. Founders and investors established banking relationships with SVB in part because of the opportunities SVB provided to network within the space. It will be difficult for other lenders who don’t have these deep relationships to replace SVB in this capacity and fill this valuable role.Continue Reading Bumpy Ride Ahead for Startups After Silicon Valley Bank Crash
Non-accredited investors are estimated to constitute approximately 92% of the U.S. population. Yet 
restrictive rules governing exempt offerings have significantly limited their freedom to invest in private offerings and prevented or discouraged issuers from selling them privately offered securities. But in a recently issued concept release, the Securities and Exchange Commission has signaled a
Every 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
Earlier this year, Union Square Ventures Managing Partner Fred Wilson famously referred to corporate VCs as “The Devil”, when he asserted that companies should not be investing in other companies, that they should be buying other companies but not taking minority positions in them, that the “access” rationale for corporate venture is a reason
In Part I of this two part series on model structures for seed rounds, I explained how the dramatic decline in the cost of launching an internet-based startup over the last 15 years primarily due to the disruptive effects of open source software and cloud computing has led to a surge in seed stage investing
The cost of launching an Internet-based startup has fallen dramatically over the last 15 years. This democratization of internet-based entrepreneurship resulted primarily from two innovations: open source software and cloud computing. During the dot-com era, Internet-based startups had to build 
infrastructure by acquiring expensive servers and software licenses and hiring IT support staff. So the
At an open meeting on October 30, 2015, the Securities and Exchange Commission by a three-to-one vote adopted final rules for equity crowdfunding under Section 4(a)(6) of the Securities Act of 1933, as mandated by Title III of the Jumpstart Our Business Startups Act. The final rules and forms are effective 180 days after publication