Written by: Marek Adamo
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A recent line of Delaware cases underscores the need for venture-backed companies to be mindful of fairness when faced with highly dilutive down-round financings and recapitalizations.
The typical scenario that leads to a highly dilutive transaction is well-known to those in the venture capital community: a VC-backed startup requires additional capital. Its board is controlled by representatives of its lead VC investors. For one reason or another, outside capital is not available and the company finds itself in a distressed financial position. The lead VC investors agree to provide additional funding, but on terms that are highly dilutive to non-participating stockholders, often at a price well below that of previous funding rounds.
Perhaps not surprisingly, this scenario has resulted in lawsuits initiated by minority stockholders, particularly if the company’s fortunes improve and insiders are perceived to have enjoyed outsized returns as a result of the dilutive transaction.
So what can corporate directors of a venture-backed company do to ensure fairness when faced with a distressed financing?
The Entire Fairness Standard
Ordinarily, corporate decisions are scrutinized under the well-known business judgment rule, under which courts will generally defer to the reasonable business judgment of the corporation’s board and executives. But when a controlling stockholder or group stands on both sides of a transaction, or when a majority of the directors approving a stock issuance have an inherent conflict of interest in the transaction, Delaware courts will apply a more stringent “entire fairness” standard to the transaction.
Entire fairness has two components – fair dealing, and fair price. Under the seminal Delaware case Weinberg v. UOP, Inc., fair dealing “embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained.” Fair price “relates to the economic and financial considerations of the proposed [transaction], including all relevant factors: assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of a company’s stock.”
When a challenged transaction is subject to the entire fairness standard, it is the defendants – generally the controlling directors – that have the burden of proving both fair dealing and fair price.
In Re Nine Systems: A Case Study of Entire Fairness in the Venture Capital Context
A recent Delaware case, In re: Nine Systems Corporation Shareholders Litigation, highlights the potential pitfalls of an unfair process when approving a highly dilutive down-round financing. The ultimate result of the case, following over 6 years of costly litigation for the defendant VC funds and directors, was a $2 million judgment awarding attorney’s fees to the plaintiffs in May 2015, even after the court found that the financing occurred at a “more than fair price.”
The Nine Systems board was composed of three directors designated by a group of its venture capital fund investors, one director representing a group of minority investors, and the company’s CEO. In 2002, facing a bleak financial outlook for the company, the Nine Systems directors approved a series of transactions culminating in a recapitalization financing, in which the investor-directors’ affiliated venture capital funds provided capital in exchange for stock that valued the company at $4 million, a valuation that the investors admitted was a “back of the envelope” determination made by one of the investor directors. The transactions were approved by the insider group of investors alone, and the minority stockholders were not given the chance to participate.
During the deliberations leading up to the transactions, the director representing the minority stockholder group – at times a lone dissenting voice – was excluded from board meetings and key information. Minority stockholder approval was not obtained, and disclosures to the stockholders following the transactions omitted key details about the venture funds that participated and the transactions’ precise terms.
As a result of the transactions, the insider VC funds’ fully diluted stock ownership of the Company increased from approximately 54% in January 2002 to approximately 80% by September, and the group of minority stockholders that became plaintiffs in the case had their ownership decreased from approximately 26% to approximately 2%. Nine Systems’ fortunes eventually turned around, and in 2006 the company sold itself to Akamai Technologies for $175 million.
After extensive litigation and trial, the Delaware chancery court found that “entire fairness” was required in the Nine Systems recapitalization transactions because of the conflicts of interest VC fund directors and the majority stockholder group. Although the court ultimately found that the $4 million valuation on which the transactions were based was a fair price due to the company’s dire financial condition at the time, the fair price “does not ameliorate a process that was beyond unfair.”
Although the transaction price was deemed to be fair, the court nonetheless exercised its “inherent equitable powers” to award $2 million of attorneys’ fees to the plaintiffs to remedy the unfair process the Nine Systems directors followed in approving the transactions.
What does Fair Process Require?
The court in In re Nine Systems noted plainly that “there is no bright-line rule on what is entirely fair.” Rather, the entire fairness standard of review is principally contextual. Even in the absence of concrete rules, this case and others have illuminated some techniques and best practices to ensure fairness that can be applied when faced with a highly dilutive, down-round venture capital financing:
- At the outset, seek an outside investor to lead the financing and to negotiate terms with the company on an arms-length basis.
- If arms-length terms are not possible, consider obtaining a formal, independent third-party valuation opinion to confirm the proposed transaction price is fair.
- Identify the potential conflicts of interest of each director and make sure the conflicts are fully disclosed to all members of the board and documented in meeting minutes or written consents.
- Form a special committee of disinterested directors to consider and approve the transaction with input from independent legal and financial advisors.
- Fully disclose the company’s business and financial position, along with all of the terms of the proposed transaction, to the company’s stockholders, and obtain the approval of a majority of the disinterested stockholders.