The role of the participating inside investors in an insider-led down round financing, who have the ability both to set the investment terms and make the investment, creates tension between management and minority stockholders on one hand, and the participating inside investors on the other. In addition, former founders or early investors not participating in the financing may perceive that the participating inside investors are attempting to secure control of the company by diluting their equity position.
Furthermore, the directors affiliated with the participating inside investors are often regarded as having a conflict of interest with regard to their approval of the down round financing. This conflict of interest creates a difficult legal environment surrounding the actions of the board members and the company.
The actions of the board of directors are governed under state law by the business judgment rule. This rule creates a presumption that business decisions made by a board of directors will be given deference by the courts if the board’s judgment is exercised diligently and in good faith. Where the board’s decision may be influenced by conflicting financial interests of the directors (a so-called interested transaction), as in a down round financing, the favorable presumption of the business judgment rule falls away. In these situations, the transaction is voidable by the shareholders or the company. Under corporate statutes in both Delaware and California, the board may successfully avoid an attempt to void the transaction by showing that the transaction was approved by a vote of the disinterested board members or a special committee, or by a vote of the disinterested stockholders or by proving that the transaction was intrinsically fair and reasonable at the time it was authorized by the board.
If the members of the board were to be found to have breached their duties, state law provides that they may be personally liable for their actions. Since most private companies don’t carry directors’ and officers’ liability insurance and may not have the cash resources to engage in sustained litigation, the threat of personal liability can be serious.
Other theories of liability have been advanced based on the controlling influence that a venture fund or its general partners may have over the actions taken by a portfolio company. These theories are based on facts which can demonstrate that a controlling stockholder has breached its fiduciary duty to minority stockholders, or that venture funds or their general partners have conspired with each other to aid and abet a breach of fiduciary duty owing to the stockholders.
There are a number of steps that a board of directors and the company can consider to reduce the risk of litigation from disenchanted stockholders when faced with a dilutive financing driven by inside investors.
- A compelling board record. Board minutes reflecting the board’s thinking and analysis are important. Board members typically should meet in person or by conference telephone as opposed to taking action by written consent, and should devote more than a single meeting to decide to proceed with a down round financing. The minutes should reflect the board’s rationale for considering a down round financing and its efforts to recruit potential third-party investors.
- Diligent assessment of alternatives. The board should attempt to demonstrate that it has considered all reasonable alternatives to the insider-led round. Although actual contacts and presentations with possible new investors are not legally required, if the company has not attempted to engage with new investors, there should be a plausible reason in the record for the board’s decision.
- Approval by independent directors. Approval of the financing terms by the independent directors, or by a special independent committee of the board empowered to authorize the financing, may allow the board to take advantage of the business judgment rule. Independent director approval may not be practical, however, in many circumstances.
- Disinterested stockholder approval. Down round financing structures typically require stockholder approval. Securing the approval of the stockholders who are disinterested helps the company defend against an attempt to void the transaction by disenchanted stockholders.
- Full disclosure of terms. Complete disclosure of financing terms is essential in a down round, with particular consideration of the benefits of the financing terms to the inside investors, the likelihood of replenishment of equity incentives to management and employees following completion of the financing, and factors that would adversely impact non-participating stockholders.
- Rights offering. Perhaps one of most important steps in an insider-led down round financing is a rights offering that accompanies or follows the financing. All stockholders of the company, and frequently including employees with vested options and warrant holders with “in the money” rights, should be permitted the right to participate in the financing on substantially the same terms as the inside investors. The disclosure or information statement provided to all stockholders of the company can serve to summarize the financing terms while soliciting the interest of potential investors. The rights offering should be structured in a manner to comply with applicable state and federal securities laws and should allow sufficient time to allow potential investors to respond to the offer.
Unfortunately, there is no single step or combination of steps that can completely remove the risk of legal exposure in a down round financing. Board members may be faced with the difficult decision of proceeding with a financing that may result in litigation or shutting down the company.