April 27, 2020 |
Although we all hope for a quick return to stability, the current environment raises the possibility of an increase in down-round financings—private company financings in which the company has a reduced valuation from its prior financing round. In recent weeks, we have observed pressure on valuations and the emergence of more onerous, less company-friendly terms in several, though certainly not all, financing rounds. Down rounds raise a number of delicate and important issues for companies and investors, including impacts on employees and investors; fiduciary duty considerations for the company’s board (and others), along with a heightened risk of stockholder litigation; and oftentimes complex structuring considerations. In this alert, we provide an overview of such issues—to serve as a refresher for those who have been through down rounds in the past and as a primer for those who have not—as well as practical steps and suggestions in navigating a down round.1 Recognizing these issues in advance can help a company and investors significantly mitigate the risk that can inhere in a down round.
Employee and Stockholder Considerations
A down round can raise several issues for a company’s employees and existing stockholders. Many private companies attract human capital using stock options or other equity awards. Raising capital at a declining price can signal to employees that the company is less valuable and may be unable to achieve a favorable exit event, which, along with the resulting dilution, can substantially reduce the retention value of outstanding awards. Depending on how the down round is structured and which stockholders participate in the down round, the financing may be dilutive to existing stockholders as well. A down round can also alienate existing investors who choose not to participate but whose cooperation and additional investment a company may desire or need in the future.
Fiduciary Duty Considerations and Stockholder Litigation Risks
Down-round financings involve significant fiduciary duty considerations for the board—and potentially for members of management and large investors as well. From a business standpoint, a down round has significant implications for a company. In addition, we have seen an uptick in private company stockholder litigation in recent years, including in the context of a down round. Without a doubt, the majority of private company deals and financings do not result in litigation, but when they do, the litigation can be lengthy, expensive, and challenging.
In any decision, a board is obligated to exercise its fiduciary duties of care and loyalty. The duty of care focuses on process and whether a board acted in an informed and deliberate manner—for example, by considering all reasonably available information, being appropriately engaged, and evaluating available alternatives. The duty of loyalty focuses on a board’s motivations and possible conflicts of interest, requiring all members of the board to act for the purpose of advancing the interests of the corporation and stockholders as a whole rather than some separate interest or allegiance. All directors owe these duties to the company and its stockholders, regardless of whether they are appointed by a particular stockholder or a class or series of stock. So long as a company is solvent, fiduciary duties run only to the benefit of stockholders.2
Beyond these fundamentals, down rounds frequently involve situations that Delaware courts may view as actual or potential conflicts of interest, which can increase the pressure on the board and its process. There are two common ways in which a conflict of interest can arise under Delaware law. The first is where half or more of the board has a special interest in a transaction. This analysis requires a director-by-director review of interests and relationships. Common examples of board conflicts in the down-round context include:
• A director is a principal of a venture or private equity fund and the fund is participating in the financing round.
• A director directly participates in the round.
• A director has a close personal or economic relationship to a party participating in the transaction—bearing in mind that 1) Delaware courts have found such a relationship to exist in several circumstances in recent years (such as a pattern of co-investing together, prior employment with a conflicted party, directors vacationing together, and directors co-owning a plane together) and 2) such relationships can be common in the private company context and are carefully scrutinized by courts.
• A director is a member of management who receives special benefits in the financing round—such as new equity awards—or is viewed as beholden to other directors who have a conflict.
There are certain related principles to have in mind when assessing board conflicts. When a director is a principal of a fund and the fund participates in a transaction or receives special benefits, the director is viewed as a “dual fiduciary” with competing obligations, to the fund and to the portfolio company. Under Delaware law, a director’s fiduciary duties to a corporation are viewed as unwavering and Delaware courts are generally unsympathetic to the difficulties posed by divided loyalties. In addition, several Delaware decisions from the past decade have stated that where preferred stock terms address a given transaction, the rights of preferred stockholders are contractual in nature and directors should prefer the interests of common stockholders in many circumstances. When directors or their funds hold preferred stock, this principle can be another basis for a conflict.
The second common way that a disabling conflict of interest can exist under Delaware law is when a controlling stockholder (or group of controlling stockholders) participates in a transaction or receives special benefits in a transaction. Control can exist at sometimes surprisingly low thresholds. For example, in one case, a prominent founder who held only 22 percent of a company’s stock was found potentially to be a controller based on his personality and influence over the company, his relationships across the boardroom, and his involvement in related transaction discussions. In another case, in a dispute over a financing and related recapitalization, a private equity fund that held 26 percent of a company’s stock was found potentially to be a controlling stockholder based on its board seats and relationships to other board members. Delaware law also recognizes the concept of a control group in certain circumstances, where stockholders are connected in sufficiently “legally significant” ways. Based on these concepts, where a fund or other stockholder has a meaningful equity stake and certain other indicia of control—and participates in or receives special benefits in a transaction—a controlling stockholder conflict may potentially exist.
Where these types of disabling conflicts of interest arise and there is a risk of stockholder litigation, the implications can be significant. The default rule under Delaware law is the business judgment rule, which provides that courts will not second guess a board’s business decision and will instead defer to the board, as long as the board appears to have acted with care, without a disabling conflict of interest, in good faith, and with a rational business purpose. Where, however, a disabling conflict of interest exists and litigation arises, the business judgment rule generally falls away and a reviewing court will instead apply the more stringent and less deferential “entire fairness” standard of review.
Under the entire fairness standard, the court examines all aspects of a board’s decision to determine if it was fair to stockholders—particularly relating to 1) the process surrounding the board’s decision and 2) the terms of the transaction and all relevant financial considerations. The underlying question in an entire fairness case is whether the board and others breached their duty of loyalty and should be liable for monetary damages. Satisfying this standard is extraordinarily difficult at the motion to dismiss stage, which means that the case is likely to proceed to discovery. Thereafter, if a plaintiff is successful at trial and damages are awarded, it is possible that indemnification and directors and officers liability (D&O) insurance may not be available (and in any event many private companies, particularly those facing the types of challenges that lead to a down round, do not have D&O insurance or sufficient assets to provide full indemnification).
Stockholder plaintiffs who assert a conflict of interest generally target a number of defendants. They will name most or all members of a company’s board and, frequently, members of management. They also frequently name large stockholders—including funds—on the basis that they either are controlling stockholders or, short of that, aided and abetted a board’s breach of fiduciary duty by “knowingly participating” in the breach. Aiding and abetting is an increasingly common and successful claim. Because entire fairness litigations are fact intensive, they tend to be protracted, expensive, and difficult to dismiss at an early stage.
Practical Process Suggestions
Given this backdrop, the central question is what exactly a board and its investors should do when considering a down-round financing. As an initial matter, there are some significant “headline” measures a company can consider implementing. We would also note that many of these considerations apply in a variety of transaction contexts that involve board or controlling stockholder conflicts.
• Independent board committees and disinterested stockholder votes. A board can consider forming an independent board committee to negotiate the financing round and/or seeking a disinterested stockholder vote. Where a board conflict exists, either mechanism can cleanse the conflict under the Delaware case law and return the transaction to the business judgment rule. Where a controlling stockholder conflict exists, both mechanisms are needed to cleanse the conflict under the Delaware case law and restore the protections of the business judgment rule. In any event, several considerations apply. Either mechanism must be done properly and carefully to satisfy the Delaware case law and should be discussed with counsel (for example, relating to whether the committee can be implemented early enough in the process and be given sufficiently broad powers to have cleansing effect). As for an independent board committee, it is important to consider whether any independent board members even exist, taking into account the various types of factors outlined above that can undermine independence, and whether the board is prepared to delegate authority to a committee. As for a disinterested stockholder vote, a company will want to consider factors such as whether such a vote is even obtainable, which stockholders qualify as “disinterested,” and whether the company is prepared to make adequate disclosures.
• Rights Offerings. A common question is whether a conflict in a financing round can be cleansed by offering all stockholders the opportunity to participate in the round—an approach known as a “rights offering.” A rights offering provides an opportunity to communicate with stockholders and to attempt to undertake the round with some even-handedness. There is some suggestion in the case law that such an offering, if done properly, can return a financing round to the protection of the business judgment rule. At the same time, Delaware judges have, at least in some circumstances, recently expressed skepticism about rights offerings, including in a litigation over a down round—particularly relating to whether stockholders have the financial ability to participate and have adequate time and information to participate on equal terms.
Whether or not a company can implement the use of an independent board committee, a disinterested stockholder vote, or a rights offering, there are a number of process steps that all companies can and should take to build the best board process and record possible. These steps will help a board arrive at an optimal decision and can prove critical in an entire fairness litigation where defendants are required to show the fairness of their decision.
• Evaluate litigation risk. The company should assess the likelihood of litigation based on the company’s stockholder base, keeping in mind two factors: 1) it only takes one stockholder to bring a lawsuit, and 2) in many recent stockholder litigations, dilutive financing rounds were challenged after a company turned itself around and engaged in a sale of control. A company is particularly vulnerable to the second scenario if it made no or inadequate disclosures in connection with the earlier financing round, because a complaining stockholder may assert that the stockholder was previously unaware of the basis for asserting a claim. If the company, with the help of counsel, determines that there is meaningful litigation risk, that determination may impact which types of process mechanisms the company chooses to pursue.
• Understand fiduciary duties. The board should understand its fiduciary duties, the potential conflicts of interest that exist, and the importance of taking into account the interests of unaffiliated stockholders. In many litigations, the courts have been critical of directors for not understanding the fundamentals of their fiduciary duties. These discussions should be appropriately reflected in the board minutes. When investors have designees on the board, those designees should understand when they are wearing their fiduciary “hat” and acting on behalf of the company and properly separate that role from the fund’s interests.
• Deliberate. The board should meet and not act exclusively or largely by written consent, in order to reflect a deliberative process. Although recusals may be appropriate in some circumstances, the board should not wrongly exclude certain directors (such as independent directors) from board discussions.
• Assess information. The board should consider all reasonably available information including about the business and its financial condition and future. In a down round, the board’s deliberations and record should reflect the company’s challenging financial situation giving rise to the need for the down round.
• Assess alternatives. The board should consider all reasonably available alternatives—including other financing sources, other types of transactions, and whether a down round is necessary. The record should reflect why the down round was necessary.
• Negotiate. The board should negotiate the round and arrive at the best transaction possible for stockholders as a whole, particularly unaffiliated stockholders. The board should take into account its fiduciary duties, the impacts of the round on unaffiliated and common stockholders, the practical business needs of the company weighed against the alternatives available, and the demands of investors. If the board’s ability to negotiate is limited by such factors as the urgent need for funds or investor demands, those realities should be documented.
• Approach valuation thoughtfully. The board and the company should carefully assess the company’s valuation, with deliberation and appropriate input from management. The courts have been critical of casual approaches to valuation. Plaintiffs and courts have also focused on prior 409A valuations that suggest a higher value for the company than is used in a financing round. If such 409A valuations exist, it may be advisable to proactively address and explain the change in circumstances in the record. Finally, if a company cannot afford a financial advisor, the board should discuss the issue, and that reality should be contemporaneously reflected in the board record.
• Consider management benefits. If management will receive benefits in the down round—such as through refresh grants—the board should carefully evaluate and document the need for such benefits, including as to their size and terms and the proper participants. This is particularly true if members of management serve on the board. In several cases, the courts have viewed the receipt of management benefits as a further diversion of value away from unaffiliated stockholders and as exacerbating the conflicts of members of management who serve on the board. A board could very well determine that such benefits are necessary from a business standpoint and should not be dissuaded from making sound business decisions because of litigation risk—but the board record should carefully reflect the board’s decision.
• Make appropriate disclosures. If the company seeks a stockholder vote from stockholders who lack insider information, the board is expected to disclose all information material to the stockholders’ decision. In any event, a down round will generally necessitate providing a notice to stockholders under Delaware law. In the down-round context, Delaware courts have stressed the importance of making appropriate disclosures in such a notice, particularly relating to the nature and extent of insider benefits.
• Have good minutes and board records. All of the company’s efforts, particularly as to the matters outlined above, have to be appropriately documented in board minutes and related materials. Minutes are go-to evidence for judges when reviewing a board decision, as numerous stockholder litigations have shown. Accordingly, boards and investors will be at a significant disadvantage if minutes do not proactively (and honestly) tell the company’s story. Similarly, where minutes do not reflect a board’s efforts or the circumstances the board faced, defendants can face an uphill battle in convincing a court that the board actually took those efforts or faced those circumstances—especially because litigation often occurs many months or years after the board’s decision. At the same time, because minutes are the appropriate forum for memorializing the board record, board members and their affiliates should be extremely mindful of the emails and text messages they send, as such electronic communications figure heavily into stockholder litigation.
Structuring and Technical Considerations in Down Rounds
A down-round transaction can involve a number of complex technical and structuring points, particularly depending on the terms of a given transaction. For a company and investors, it is important to work with capable counsel who understand these issues.
At a minimum, a down-round financing may trigger the anti-dilution provisions of existing preferred stock terms, which generally allow the relevant preferred stockholders to receive a more favorable conversion rate (for purposes of converting into common stock) if new stock is sold below a certain price. Such adjustments typically also involve a correlative improvement in the affected stock’s voting power. A company and investors considering a down round will want to consider the impacts of such adjustments. Many certificates of incorporation provide that preferred stockholders can waive the application of such adjustments upon a specified vote of the existing stockholders, which may be of interest if the vote is obtainable. Where such a provision does not exist but there is a desire to avoid the application of anti-dilution adjustments, the company’s certificate of incorporation can potentially be amended to alter or avoid the adjustments. In that case, however, it is important to consider whether such an amendment triggers particular stockholder votes—including on a class- or series-wide basis—under the company’s existing protective provisions or under the Delaware corporate statute.
Down-round financings are oftentimes structured as “pay-to-play” transactions—although they do not need to be unless the structure is necessary to achieve the required levels of investment. A pay-to-play structure essentially provides that existing preferred stockholders must participate in the new round at a specified amount or else suffer some negative effect on their existing holdings. For example, a pay-to-play structure may provide that non-participating holders of preferred stock have their shares converted into common stock, while participating stockholders either retain their preferred stock or receive some “better” series of preferred stock in place of their preexisting stock.
Pay-to-play structures in particular raise complex, though oftentimes surmountable, technical issues. For example, if non-participants’ preferred stock will be converted into common stock, the parties and their counsel will need to determine how that conversion will occur: Does the company’s certificate of incorporation allow preferred stockholders to trigger a conversion to common stock upon a specified vote of stockholders, and is that vote achievable? Or will the certificate need to be amended? A charter amendment, again, could trigger certain votes under a company’s existing protective provisions or under the Delaware statute. If the certificate is amended, conversations frequently arise over whether the disparate treatment of participating versus non-participating stockholders should be imposed directly in the charter or outside of the charter—with different technical issues attending to each approach. Parties sometimes negotiate additional complexity—for example, reverse stock splits, the conversion of preferred stock into a harsher ratio than 1:1, applying the pay-to-play to only certain stockholders, or the conversion of existing and non-participating preferred stock into a new series—which will raise additional but related types of technical issues.
How to arrive at the appropriate structure for a down round relates back to the themes discussed earlier in this alert. From a fiduciary and process standpoint, a board will want to evaluate which terms are actually needed to accomplish the financing round. Investors leading the round will naturally require that the round be conducted on certain terms, but they will want to be cognizant of the potential litigation risk that they and the company face and how those terms will look in hindsight should litigation arise. If the entire fairness standard is applied in a stockholder litigation, a reviewing court will examine all of the terms of the transaction to determine if they were actually fair to existing stockholders, particularly the unaffiliated stockholders.
Down-round financings could appear with increasing frequency in the current environment. They may be necessary from the vantage point of the company and investors, but all parties will want to be highly aware of the implications of a down round—on employees and existing stockholders, for fiduciary and process issues, and as to technical and structuring issues. Capable counsel can help all parties achieve the right outcome. Very importantly, companies and investors can significantly mitigate the risk to the transaction and to themselves by implementing common-sense and achievable process mechanisms. A good board process—including a documentary record supporting that process—and a careful approach to structuring will also better position the company for the future, as the company undertakes additional transactions and potentially needs further investment or support from existing stockholders.
Compliments of Wilson Sonsini Goodrich & Rosati – a member of the EACCNY.