Just over a month ago, many sectors of the U.S. economy came to a sudden stop as the federal and state governments ramped up their efforts to contain the spread of the COVID-19 pandemic. As governors issued orders requiring individuals to stay at home and non-essential businesses to close their doors to customers, many businesses experienced severe contractions in revenue. Since then, the federal government has adopted (and even expanded funding for) the CARES Act to make loans available to small businesses to enable to them to make payroll, avoid laying off or furloughing their employees, and pay certain other expenses. However, portfolio companies of venture capital and growth funds have experienced legal obstacles to accessing this program (in part due to affiliation rules). Even the CARES Act loans that are available to these portfolio companies only enable the financing of 2.5x of monthly eligible payroll costs.
Until the COVID-19 pandemic is contained and the U.S. economy rebounds, fund portfolio companies will likely be forced to raise capital in order to support their operations, even if their operations are conducted on a scaled-back basis. For the last few years, valuations for portfolio companies have tended to rise over subsequent financing rounds as these companies have demonstrated proof of concept, experienced incredible growth rates or otherwise increased their probabilities of success.
In today’s troubled environment, if a portfolio company requires additional equity financing, there is a good reason to believe that the financing will most likely be a “down round” financing – i.e., a financing round in which the pre-money valuation of a company is below the post-money valuation of its last round. If an existing stockholder cannot participate or chooses to not participate in the down round financing up to its pre-existing ownership percentage, the round will be “dilutive” to such stockholder. If the down round is completed at a sufficiently depressed valuation relative to the valuations for prior rounds, such stockholder’s interest could be “washed out” (i.e., the stockholder’s percentage interest becomes relatively inconsequential) or “burned out” (i.e., eliminated altogether).
The U.S. private capital markets have not seen dilutive down round financings en masse since 2001, when the dot com bubble burst, and the Great Recession of the late 2000s and early 2010s, when the global financial markets collapsed. Given the rarity of these types of financings over the last decade, this article provides a refresher on the liability exposure to fund stockholders and directors of a portfolio company conducting a dilutive down round financing and the practices available to reduce this exposure.
The legal risks to a fund participating in a down round financing arise primarily from the status of its representatives on the board of the portfolio company being deemed to be “interested” in the financing and/or the fund using its control over the company or the company’s financing process, allegedly, to take advantage of the company’s minority stockholders. The board and/or controlling stockholder could have exposure for significant damages to the diluted stockholders. If a director is found liable and was serving on the board at the request of a stockholder, the stockholder may also have an obligation, under its organizational documents or insurance policies, to indemnify or reimburse the director for such liability. A stockholder could also be found liable for “aiding and abetting” a breach of fiduciary duty by the board of the portfolio company. The potential for liability on the part of a director or controlling stockholder to diluted stockholders of the portfolio company does not go away once the down round financing has been completed. In the years following a down round financing, when a company may have completed subsequent rounds at rising valuations or even after going public, a diluted stockholder could assert claims for breach of fiduciary duty related to the down round, with damages potentially growing over time as the company’s fortunes improve.
A director of a corporation generally has fiduciary obligations to the corporation and its stockholders that are enforced through his or her duties of care and loyalty. Notably, the director’s fiduciary duties to a corporation’s stockholders generally run to the corporation’s common stockholders, not its preferred stockholders. The preferred stockholders’ protections are based on the contractual rights that they have negotiated with the corporation, and preferred stockholders are entitled to the benefit of director fiduciary duties only insofar as such duties relate to matters which fall outside the subject area of their contractual rights.
So long as a director complies with his or her fiduciary duties, the business judgment rule will protect his or her conduct in relation to the financing. However, a director will lose the benefit of this rule if the director is deemed “interested” in the financing. A director is generally considered “interested” if the director appears on both sides of a transaction or receives a personal benefit from a transaction not received by stockholders generally. In the context of a dilutive down round financing, a director will be deemed “interested” if the director is a representative of the fund that is diluting other stockholders through the fund’s participation in the round. An individual will likely be deemed a representative of a fund if such individual works for the fund or its related management company or is specified by the fund as its director nominee for purposes of a stockholder voting agreement, which may be embedded in a stockholder agreement, or, in the case of equity-related documents based on National Venture Capital Association (NVCA) forms, in a separate voting agreement. When a majority of the portfolio company’s board consists of interested directors with respect to a dilutive down round financing, the board’s approval of such financing will not be protected by the business judgment rule, in which case the board’s conduct will be reviewed under the “entire fairness” standard, which, at least in the case of the Delaware courts, is the strictest standard of review applied to corporate matters.
A stockholder generally does not have fiduciary duties to a portfolio company and can act in its best own interests with respect to the company. However, if the stockholder “controls” the portfolio company, the stockholder may, under certain circumstances, have fiduciary duties to the company’s minority stockholders. A determination of “control” will arise if the stockholder owns a majority of the company’s voting securities or, even if not the majority owner, exercises actual control over the company, whether due to contractual arrangements, overlapping management or other reasons. A controlling stockholder has a duty to not use its control over the company or over the financing process to derive a benefit from the financing to the detriment of the other stockholders. Consequently, a dilutive down round financing in which a controlling stockholder participates may be subject to review under the “entire fairness” standard.
Essentially, a dilutive down round financing will meet the “entire fairness” standard if it reflects an arm’s length negotiated transaction, albeit a hypothetical one. The “entire fairness” standard, when applied to the financing, has two parts — “fair dealing” (i.e., the financing process was fair) and “fair price” (i.e., the terms of the financing were fair) — although in practice, a court’s analysis may look at all aspects of the financing. In litigation challenging a financing subject to entire fairness review, the board or controlling stockholder, as applicable, will have the burden to prove that the transaction is entirely fair. This burden shifts to the party challenging the transaction (i.e., the aggrieved party must prove that the transaction is not entirely fair) if the transaction has been approved by a special committee of independent and disinterested directors or by a majority of disinterested stockholders. However, disinterested stockholder approval alone does not cure defects in the underlying transaction process or the valuation obtained. Nevertheless, this burden shifting can be very significant practically, since affirmatively proving “entire fairness,” whether as to valuation or otherwise, may be difficult.
Reducing the Liability Exposure
A fund portfolio company and its board should adopt one or more of the following practices (to the extent feasible under the circumstances) to reduce the likelihood that its directors and its controlling fund stockholder are found liable for a dilutive round financing not satisfying the “entire fairness” standard in the event of litigation.
- Build a Supportive Record. A portfolio company should maintain a record of the deliberations of its board and any special committee for the financing, the decisions taken by these bodies, and the relevant facts. The record should be detailed enough so that there is no uncertainty as to key events or circumstances at the time, but not be so detailed so as to enable a party challenging the transaction to spin a narrative that distorts what in fact happened. Notably, the record should reflect that the board and/or committee was apprised of its duties (including that its duties generally run to the common stockholders, not preferred stockholders) and gave due consideration to them. Whenever possible, there should be a deck memorializing key items being presented to the board or committee, with the deck circulated as far in advance of a board or committee meeting as possible. A board or committee should hold meetings (whether telephonically or otherwise) to deliberate instead of just acting by written consent to carry out a fait accompli, and the minutes of meetings should reflect not just that “deliberations occurred” but that key facts and circumstances (e.g., cash position and burn; alternatives to the financing) were actually considered. With the assistance of legal counsel, a robust contemporaneous record can be prepared that does not materially delay the down round financing and carries a meaningful part of the burden of demonstrating to the court that the parties being scrutinized met their obligations.
- Form a Special Committee. Ideally, interested directors should not control the board approval process for the financing. Instead, the board should form a special committee composed of independent and disinterested directors to evaluate, negotiate, and approve the down round financing and its material terms and conditions. The use of such a committee is recognized as shifting the burden of proving “entire fairness” from the board or controlling stockholder to the stockholders challenging the transaction. The use of a special committee, however, may not be a realistic option for a portfolio company of a fund. The directors of the portfolio company may be primarily personnel of the fund or its associated management company or be nominated or designated by the fund to serve as directors, and in either case, therefore may be “interested” in the financing. Management directors on the board of a portfolio company may be also deemed “interested” directors insofar as their compensation is set by other directors who are representatives of the fund. A third party who is serving on the board at the request of the fund or a group of stockholders may also be deemed to be “interested” if he or she has a web of relationships with the fund or its other portfolio companies. Further, for a portfolio company that is running out of cash, there may simply not be enough time to form a special committee and for committee members to meet separately in addition to attending board meetings. Courts have not rejected dilutive financings simply because of the absence of a special committee. Whenever possible, though, a special committee should be formed.
- Get Disinterested Stockholder Approval. The approval of a dilutive down round financing by disinterested stockholders also shifts the burden of proving “entire fairness” from the board or controlling stockholder to the stockholders challenging the transaction. However, the portfolio company’s urgent need for financing may render this practice impracticable if significant lead time is required to prepare disclosure documents, contact the disinterested stockholders and explain the need for the financing to them, and to enable them to review, sign, and return the materials. As with a special committee, though, disinterested stockholder approval should be obtained when possible.
- Document the Business Exigency. Business exigency is perhaps the strongest factor favoring defendant directors or a controlling stockholder when a dilutive down round financing is challenged. If the portfolio company is in dire need of financial support and apparently unable to obtain financing elsewhere, courts tend to reject challenges to the financing from nonparticipating stockholders, even though many other factors would suggest otherwise. Courts appear to recognize that a board may have had little choice but to approve a dilutive financing to keep a business afloat, though the board’s actions leading to the dire financial condition of the portfolio company could potentially be attacked as a failure to meet their duty of care (e.g., approval of the payment of dividends by the company to its stockholders or incurring additional indebtedness to fund such payments). Therefore, in connection with a dilutive financing, a company should carefully document its immediate cash flow needs and the consequences to the company of failing to meet such needs. Moreover, the actual terms of the financing should be commensurate with the company’s needs. A court is more likely to accept a financing as emergency financing if the amounts invested are consistent with the company’s cash needs in the near term, since the board exposes itself to increased risk if it accepts excessive funding even in an emergency. The board’s legal position would also be improved if part of the financing was earmarked to engage an independent consultant or investment bank to either assist the company to raise external (independent) capital or help properly value the company’s shares.
- Solicit Participation by Existing Stockholders. The board or special committee should offer the right to participate in a down round financing to all existing stockholders so that they can maintain their pro rata ownership of the portfolio company, regardless of whether or not such stockholders have preemptive rights. If the company must close on the financing immediately, consider offering the stockholders not participating in the initial closing the opportunity to purchase, within a prescribed period after the initial closing, up to their pro rata share of the down round financing. There should be robust disclosure of the terms of the financing and the background to the financing (including the board or committee’s deliberations and process) in writing or via email to the stockholders, to the extent time permits the preparation of such disclosure. While the offer by the portfolio company to founder or management stockholders of participation in the down round financing may appear to render the financing fair, more often than not, the founder or management stockholders will not have the ability to come up with their pro rata share of the financing to maintain their pro rata ownership of the company. Accordingly, the courts may not consider this right of participation enough by itself to enable the financing to meet the “entire fairness” standard. In any event, we strongly encourage participation in the financing to be offered to existing stockholders whenever possible, since doing so eliminates a challenge to the transaction at least on this basis.
- Solicit Outside Investors. The solicitation of outside investment is another strong factor favoring defendant directors or a controlling stockholder when a dilutive down round financing is challenged. The board or special committee of the portfolio company should solicit new investors in order to determine whether outside investment is available on the same or better terms as the down round financing and, therefore, whether the valuation embodied by the down round is “fair.” To the extent that a portfolio company has insufficient cash to sustain its operations and pay its debts while searching for and negotiating with outside investors, the board or special committee should consider, in lieu of a down round financing, a short-term solution in the form of bridge financing from its existing stockholders, with such financing automatically converting into a subsequent third-party round of equity financing in a material amount. A controlling stockholder should resist the temptation to demand excessive warrant coverage or a punitive discount rate in negotiating the terms of the bridge financing, even if obtainable, as these terms will likely expose the controlling stockholder and/or its representatives on the board of the portfolio company to costly litigation with unfavorable results once the company’s fortunes have recovered.
- Get a Fairness Opinion. To further support the value determination, the board or special committee should consider engaging a financial advisor to perform an independent valuation of the portfolio company, and to deliver an opinion to the board or committee with respect to the fairness to existing stockholders of the valuation reflected by, and the other material terms of, the down round financing. However, obtaining a fairness opinion may not be a viable option for a company running out of time to close a financing and without available funds to pay a retainer to a financial advisor. In such event, the board or committee should make determinations to such effect and document them. In addition, courts have questioned the usefulness of hastily prepared fairness opinions. The board or special committee should balance the benefit of obtaining the fairness opinion against its cost and potential weaknesses.
- Watch Your Language. Avoid characterizations of the down round financing as a “washout” or “burnout” financing, and avoid making affirmative statements that existing stockholders should be diluted because of the company’s dire financial condition or poor performance. Remember that communications among directors of a portfolio company, or between a fund and its representatives on the board of a portfolio company, generally will be discoverable in the event of litigation.
Dilutive down round financings by fund portfolio companies may result in their directors and controlling stockholders having liability for such financing under the “entire fairness” standard in the event of litigation. This liability exposure can be reduced by implementing one or more of the practices described above in connection with the financing, in consultation with legal counsel well versed in the “entire fairness” case law and these related practices.
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