United States: Delaware Court Finds Flaws By Board In Sale Of VC-Backed Company But Finds Price Fair

The Delaware court of chancery found recently1 that the sale of venture-backed Trados Inc., for a purchase price that was less than the sum of the preferred stock's preferences plus the payments required under a management incentive plan, raised conflicts that triggered the court's "onerous" entire fairness review standard. The court criticized the process followed by the company's directors, but ultimately determined that the entire fairness standard was met because, given the company's value and prospects, receipt by holders of common stock of no consideration for their shares nonetheless represented a fair price.

The decision provides several reminders for boards considering the sale of venture-backed companies and other companies with multiple classes or series of stock:

  • There may be a conflict of interest between the common stock and the preferred stock when a company, at the time it is sold, has prospects for future improvement that could lead to better value for the common stock.
  • In such circumstances, directors may need to consider the interests of the common stock, as the residual claimants on the company, over those of the preferred stock, at least to the extent consistent with the company's contractual commitments to the preferred stock.
  • While courts have not required that directors follow any particular process to fulfill their fiduciary duties, directors can consider various procedural steps to help address these conflicts of interest, help show fairness if required, and reduce litigation risks. Such steps, as noted by the Trados court, could include using a special committee of disinterested directors, obtaining a fairness opinion, or conditioning the sale on approval of the disinterested holders of common stock.

BACKGROUND

Trados, a Delaware corporation, was founded in 1984. Starting in 2000, the company sold several series of preferred stock to venture capital investment firms, providing the VC investors with liquidation preferences and other relatively common preferred stock features such as cumulative dividends and, for some series, participation rights. The VCs also received rights to designate directors; several designated partners of their firms, and one designated an unaffiliated technology consultant who had served in director or executive officer capacities with several of the VC's other portfolio companies. Trados grew, but never became profitable. In 2004 the board brought in new management and adopted a management incentive plan ("MIP"). The new management obtained venture debt financing, after the existing VC investors declined to provide additional capital, and Trados' results began to improve.

The board also pursued a sale of the company. Trados ultimately agreed in 2005 to be sold for $60 million, with $7.8 million paid to management under the MIP and the remaining $52.2 million paid to preferred stockholders (which was less than their aggregate preference of approximately $58 million). Common stockholders received nothing for their shares.

A holder of common stock challenged the sale as a breach by the Trados directors of their fiduciary duties, and also sought appraisal. The court rejected, for the most part, a motion to dismiss in 2009, and held a trial in early 2013.

COURT'S ANALYSIS

1. Conflicts Trigger Entire Fairness Review.

Board Duties to Common. The court noted that the duty of the board is to maximize the value of the company for the benefit of residual claimants, rather than for the benefit of contractual claimants, such as the holders of preferences. The court also noted "where the interests of the common stockholders diverge from those of the preferred stockholders, it is possible that a director could breach her duty by improperly favoring the interests of the preferred stockholders over those of the common stockholders."

Conflicts of Interest. The court determined that a majority of the Trados directors were conflicted, triggering application of the entire fairness standard. In particular, the two management directors had interests in the MIP payments, which the court found would be significant to each of them personally; the directors affiliated with the VCs were more interested in spending their time and resources on potentially higher return ventures; and one of the two outside directors had significant relationships with one of the VC investors that resulted in a sense of "owingness" to the VC firm.

The court described the VC business model as causing VCs "to seek outsized returns and to liquidate (typically via a sale) even profitable ventures that fall short of their return hurdles and which otherwise would require investments of time and resources that could be devoted to more promising ventures." The court acknowledged that the VCs' preferred stock investments might generally incentivize them to maximize the value of a company. However, the court also noted that, with the liquidation preferences, the VCs' economic incentives with respect to a sale of the company could diverge from the incentives of common stockholders, particularly for companies that fall between "complete failure[s]" and "stunning success[es]," since the VCs, unlike the common stockholders, might "gain less from increases ... than they lose from decreases" in the company's value. The court examined the motivations of the Trados directors affiliated with its VC investors and found that they wanted to exit the Trados investment, consistent with the interests of their VC firms. The court also noted the "web of interrelationships" within the Silicon Valley startup community that might be said to compromise an otherwise "outside" director's independence.

2. Application of Entire Fairness.

Under the entire fairness standard, the court examined both the process by which the sale was initiated and pursued, including the timing of the sale ("fair dealing"), and the price obtained ("fair price").

Fair Dealing. The court criticized several aspects of the sale process:

The court found that the sale was pursued because the VC directors wanted to exit, for the reasons discussed above, rather than to manage the company to increase the value that might be available to common stockholders.

The court noted that the MIP paid management, at least in part, ahead of the preferred stock's preferences, but, once the preferences were filled, paid management proceeds that might otherwise go to common stockholders until the maximum MIP payout was achieved. The MIP also included a "cutback" pursuant to which any proceeds management received for their own common stock or options reduced their proceeds under the MIP. The court concluded that the MIP thus incentivized management to act in alignment with preferred stockholders rather than with common stockholders.

Finally, the court noted the apparent failure of the directors to recognize their duty to the common stock or to consider procedural steps that, while not required, could help to protect the interests of the common stock and thus to provide evidence of fairness.

Fair Price. The plaintiff contended that Trados' prospects were improving and that common stockholders would have received some value if Trados had continued on a stand-alone basis. The court made a detailed comparison of the respective valuation experts' analyses, added its own analysis, and concluded that paying nothing was a fair price for the common stock, since, even assuming a best case scenario for continued operations, Trados did not have "a realistic chance of generating a sufficient return to escape the gravitational pull of the large liquidation preference and cumulative dividend."

OBSERVATIONS

  • Importance of Acknowledging Duty to Common Stock. The court reiterated that directors generally owe fiduciary duties to the holders of common stock and not to the holders of preferred stock, except with respect to rights shared equally by the two classes. Directors should show that they understand both this distinction and that the interests of the holders of the two classes might diverge, including that the holders of common stock, in some circumstances, might be better off without a sale of the company, and that the directors considered steps to address it.
  • Structuring Management Incentive Plans. Boards should consider the impact of MIPs on management incentives in sale situations, and avoid aligning management with the holders of preferred stock, in potential conflict with the interests of the common stock, under reasonably likely scenarios for the company.
  • Other Governance and Process Protections. Directors should consider various procedural steps that could protect the interests of the common stockholders. The court acknowledged that these steps are not necessarily required, and that there may also be reasons for not using them (such as the cost involved in obtaining a fairness opinion), but noted that they could serve as evidence of fairness. Practices named by the court included: o Use of a special committee of disinterested directors;
    • Obtaining a fairness opinion as to the objective fairness of the transaction; and
    • Conditioning the closing of the transaction with approval by a majority of the disinterested shares of common stock.
  • Analyzing Director Independence. The court's conclusion that one of the two directors not affiliated with the VCs or the company was nevertheless conflicted hinged on the longstanding relationship such director had with one of the VC investors, rather than solely on the direct material benefit to such individual from the sale. The court's decision thus highlights the need in some circumstances for more holistic notions of where director conflicts may arise.

CONCLUSION

While the court ultimately found in favor of the directors, based on its factual analysis of the price, the time and cost of defending the claims seem high. Directors, in fulfilling their fiduciary duties, should consider whether implementing some protective measures or utilizing other methodologies may make their actions easier to defend or discourage potential plaintiffs from bringing suit in the first place.

Footnotes

1 In re Trados Inc. Shareholder Lit'n (Del. Ch. Aug. 16, 2013).

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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