Archives for December 2008

Should board members representing inside investors vote on the board resolutions authorizing the insider-led down round?

December 27, 2008 By Yokum Leave a Comment

As a theoretical matter, entrusting disinterested directors to approve a down round or dilutive financing is an excellent way to protect the insider-affiliated directors against claims from stockholders. In this situation, the board may establish a special committee comprised only of disinterested directors to negotiate and approve the financing. In a perfect world, the insider-affiliated directors would not participate in any of the board discussions to approve the transaction.

However, establishing an independent committee of disinterested directors to approve the terms of an insider-led down round financing is often impractical. Oftentimes, there aren’t any disinterested directors to approve the transaction. All of the directors affiliated with investors participating in the financing will not be disinterested. In addition, directors that are also employees may not be considered disinterested because they have a vested interest in completing a financing in order to keep their jobs.

In many scenarios, the inside directors will have to vote in order to have a valid board action. However, the board will not have the benefit of the business judgment rule unless a majority of the disinterested directors or disinterested shareholders approve the transaction. In this situation, courts will apply the entire fairness doctrine as the standard of review of director actions, which presumes that the directors acted unfairly and places the burden of proof on the directors to show fair dealing and fair value for the company.

Why do preferred stockholders have odd economic incentives upon a sale of company when they have non-participating preferred stock or particpating preferred stock with a cap?

December 20, 2008 By Yokum Leave a Comment

Even savvy investors often don’t understand the subtle nuances on economic incentives that result from non-participating preferred stock or participating preferred stock with a cap in the event of a sale of company.

Assume a simple cap table of:

10,000,000 shares of common stock

10,000,000 shares of Series A preferred stock

Also assume that the Series A preferred stock has a $1.00/share liquidation preference and is non-participating.

If the company is sold for between zero and $10M, then all of the merger consideration would go to the holders of Series A.

If the company is sold for $10M to $20M, the holders of Series A would still receive $1.00/share as a rational Series A holder would never convert his/her shares to common as the Series A holder would receive more from the Series A liquidation preference than as a holder of common. For example, if the merger consideration is $15M, then the Series A would receive $1.00/share and the common would receive $0.50/share. Thus, the holders of Series A are indifferent between sale prices from $10M to $20M, which may lead to odd economic incentives. Hypothetically, a venture capital fund holder of Series A might not want a company to argue hard over merger valuation with an acquiror if there is no marginal benefit to the fund and there is a risk that the deal may fall apart.

If the company is sold for over $20M, the holders of Series A would convert to common (assuming that they are economically rational). For example, if the merger consideration is $30M, then the common would receive $1.50/share (assuming all Series A converted). Of course, if some holders of Series A did not act in their optimal economic interest and convert, then the merger proceeds available to the common would increase and the common would receive greater than $1.50/share.

Similarly, if the Series A is participating with a cap, there will be a range of merger consideration values where the holders of Series A will be indifferent because the cap has been met, but it still does not make economic sense for the Series A to convert.

In the same example, assume that the Series A has a $1.00/share liquidation preference and is participating with a 3X cap.

Like the non-participating preferred, if the company is sold for between zero and $10M, then all of the merger consideration would go to the holders of Series A.

For merger consideration greater than $10M but less than $50M, the Series A participates with the common on the amount over $10M. For example, if the merger consideration is $20M, the holders of Series A would receive $1.50/share, or an aggregate of $15M (which represents the $10M liquidation preference and $5M of participation with the common), and the holders of common would receive $0.50/share, or an aggregate of $5M.

If merger consideration is $50M, the holders of Series A would receive $3.00/share, or an aggregate of $30M (which represents the $10M liquidation preference and $20M of participation with the common), and the holders of common would receive $2.00/share, or an aggregate of $20M. At $50M, the Series A hits the 3x cap on participation by receiving $3.00/share.

If the company is sold for $50M to $60M, the holders of Series A would still receive $3.00/share as a rational Series A holder would never convert his/her shares to common as the Series A holder would receive more from the Series A liquidation preference than as a holder of common. For example, if the merger consideration is $55M, then the Series A would receive $3.00/share and the common would receive $2.50/share. Thus, the holders of Series A are indifferent between sale prices from $50M to $60M, which may lead to the same odd economic incentives as the non-participating preferred stock, albeit at higher transaction values.

If the company is sold for over $60M, the holders of Series A would convert to common (assuming that they are economically rational). For example, if the merger consideration is $60M, then the common would receive $3.00/share (assuming all Series A converted).

Please see the liquidation preference spreadsheet and program some examples if you want to proof this yourself.

If a down round financing is led by a new outside investor, does the board need to be concerned about the business judgment rule?

December 13, 2008 By Yokum Leave a Comment

Having a new lead outside investor substantially improves the legal risk in a down round financing. In most cases, the outside investor acting as lead will agree to invest the largest amount of money in the round, will perform the diligence necessary to set the valuation and pricing, and will dictate the terms of the transaction, including the amount of additional investment required or permitted of the inside investors. In these circumstances, even where the new financing is at a reduced valuation, the conflict of interest issues are normally eliminated. A rights offering is typically not considered necessary, although the company may still conduct one in order to solicit additional investor investor interest. Disinterested board and disinterested stockholder approval procedures are typically not necessary, although following them will also decrease risk.