Startup Company Lawyer

You are here: Home / Archives for Yokum

What does a liquidation preference spreadsheet look like?

By 25 Comments

I’ve had some comments and emails asking if I would publish a liquidation preference spreadsheet.  Basically, when a company is thinking about an M&A deal, the first thing that everyone wants to know is how much money does everyone get from the merger proceeds.

Download Sample Liquidation Preference Spreadsheet

The spreadsheet is fairly straightforward.  You can plug in the deal value (merger proceeds) and spreadsheet automatically figures out exactly how much each founder gets and what the return per share is for each class/series of stock.  The spreadsheet determines if a series of preferred stock should convert based on whether the series would receive more merger proceeds as a holder of preferred stock or common stock.

The spreadsheet also takes into account whether options and warrants should be exercised or not.  For example, if the deal value is too low, the common stock merger consideration price per share may be lower than the exercise price for options.  Then the options will not be exercised.  Whether the options are exercised or not will affect the number of outstanding shares of common stock and therefore, the common stock price per share.

This spreadsheet assumes three rounds of financing with non-participating preferred stock, a couple of tranches of warrants (as a result of a bridge loan or two), and options with various exercise prices.  In my redacting of information in the spreadsheet, I’m sure that there is something broken.

I might post a spreadsheet in the future with more bells and whistles, such as the ability to easily manipulate the formulas for senior preferred and participating/non-participating preferred, as well as graphs to show the merger proceeds per share as aggregate merger proceeds increases. Please don’t expect any support or explanation on how the spreadsheet works. I already told someone who had emailed me that I might consider providing a tutorial if she brought my a decaf soy latte and a Sprinkles cupcake some afternoon.

Filed Under: M&A

What deal terms appear in down round and highly dilutive financings?

By 2 Comments

[This is the first of a series of posts on down round and dilutive financings.]

I don’t want to add to the “sky is falling” in Silicon Valley theme that I’ve read on various blogs, but given recent economic conditions, a review of how venture financing deal terms may change seems warranted.

Existing investors generally want new investors to set valuations and deal terms in subsequent rounds of financing for a company. However, these deal terms typically become more investor favorable as raising money becomes more difficult. In many cases, existing investors are left to fund the company as new investors are unwilling to invest.

Unlike conventional, “up-round” financings which have a fairly predictable range of terms, the structures and terms of down round financings are variable.  A “down round” financing typically occurs when a company issues securities to investors at a purchase price less than that paid by prior investors.  Absent anti-dilution protection, a down round financing will dilute both the economic and voting interests of the prior stockholders.  A “washout” or highly dilutive financing, is an extreme form of down round financing that significantly reduces the percentage ownership of prior stockholders.

Below are some features of down round and highly dilutive financings.

  • Valuation.  Obviously, valuations may decrease as the financing environment becomes more difficult.
  • Liquidation preference.  Liquidation preferences are also typically more investor favorable than previous rounds.  These financings may involve the issuance of participating preferred stock with senior liquidation preferences at multiples of the purchase price.  Please keep in mind that the liquidation preference may be the most important right of the preferred stock, as the percentage ownership that the preferred stock represents upon conversion into common may become meaningless from a practical perspective if the common stock is worthless (see below).
  • Aggressive convertible debt terms.  Many investors in highly risky financings will prefer senior secured convertible debt over equity securities in the event the company has to file for bankruptcy. These financings may involve the issuance of secured convertible debt (sometimes coupled with warrants) senior to other debt with a payment of a multiple of the principal amount on a sale of company (or conversion into equity securities at a multiple of the principal amount). 5x multiples were not shocking during the post-dot com bust 2001 era. In these situations, voting control, as reflected by percentage ownership and affected by valuation, is a secondary concern to the return on a sale of company and protection in bankruptcy.
  • Milestone-based or tranched financings. Investors may be reluctant to invest large amounts of money in a risky financing.  Instead, they may provide enough money for a company to find someone willing to buy them or achieve a particular milestone that decreases investment risk.  These “IV drip” bridge financings may provide a couple to a few months of operating cash and are typically structured as secured convertible debt with a multiple X return upon a sale of company.
  • Conversion of preferred stock. Some financings involve a conversion of previous series of preferred stock into common stock in order to decrease the aggregate liquidation preference.  In some companies, previous financings may have resulted in an aggregate amount of liquidation preferences that may render the common stock worthless.  For example, due to multiple X liquidation preferences or raising multiple rounds of financing, a company that has raised $50M in financing may have $100M in liquidation preferences.  However, the company may realistically have a problem getting sold for greater than $100M in poor economic conditions where company valuations are low.
  • Pay to play.  Many dilutive financings implement a pay to play mechanism where stockholders not participating in the financing are penalized by being forced to convert into common stock. Absent a pay to play mechanism, stockholders may not have an incentive to risk additional investment into a company due to a free rider problem.
  • Enhanced rights for participating investors.  In some financings, existing stockholders that participate in the financing may receive additional benefits over non-participating stockholders.  This is similar to pay to play provisions that penalize existing stockholders for not participating in the financing. For example, existing stockholders that participate in a financing may have their preferred stock repriced via an adjustment to the conversion ratio, which would effectively give them the benefit of a lower valuation for their original investment. Alternatively, participating stockholders may have the opportunity to exchange their existing preferred stock for new preferred stock with more favorable rights, such as a senior liquidation preference.
  • Expanded investor protections.  Some investors may request more extensive representations and warranties, broader indemnification protection, D&O insurance, and other similar investor-favorable protections.
  • Drag-along rights.  Investors may require drag-along provisions that require existing investors to vote in favor of a future sale of company or an amendment of the certificate of incorporation to create a new series of preferred stock to facilitate a future financing (even before the terms of the preferred stock have been established).
  • Employee retention plans.  Some financings may involve large stock option grants to offset the dilutive effects of the financing to employees.  In some companies, aggregate liquidation preferences or multiple X returns on convertible debt may render the common stock worthless.  In these situations, stock options may not be adequate to hire and retain employees.  Instead, companies may implement retention plans where employees receive a certain percentage of sale proceeds upon a sale of company.

What is upgradeable Series A preferred stock?

By 1 Comment

Occasionally, I see a new provision in a term sheet, which keeps things interesting for me. I’ve decided to call this type of Series A preferred stock “upgradeable” (after recently realizing that there are economy class plane tickets that aren’t upgradeable despite having system-wide upgrade certificates). The term sheet provides:

The Series A Preferred shall also be convertible into any future series of Preferred Stock (the “Future Preferred”) under either of the following circumstances: (a) if such conversion is approved by the Board or (b) if such conversion is in connection with a future Preferred Stock equity financing in which the Company’s fully diluted pre-money valuation is greater than the Company’s fully diluted post-money valuation immediately following the Series A Financing contemplated by this term sheet (a “Future Financing”), in either case, on a one-for-one basis (subject to anti-dilution adjustment) at the option of the holder; provided however, if such conversion is in connection with a Future Financing, that the holder may convert into shares of Future Preferred only in the event that all of such shares of Future Preferred received by the holder upon conversion are sold to an Approved Investor (as defined below) no later than 90 days following the first closing of the Future Financing at a price per share no lower than the price per share at which the Company sells shares of such Future Preferred in the Future Financing and, provided further, that such Approved Investor is not an affiliate, family member, or related party of the holder. For the purposes of the preceding sentence, “Approved Investor” means (1) a bona fide institutional investor, or (2) any investor who has invested at least $1 million in the Company. For the avoidance of doubt, any conversion into Future Preferred in connection with a Future Financing that does not result in a sale of such Future Preferred to an Approved Investor on the terms set forth above shall be void, and such Future Preferred shares shall be deemed re-converted into Series A Preferred Stock automatically and without further action on the part of the holder.

Basically, this is a variation on Series FF stock that I have previously written about.  Instead of the stock being issued to founders, the “upgradeable” Series A stock is issued to early investors.  If the early investors want to sell their stock to investors in a later financing round, the Series A stock is convertible into the later round of preferred stock.  This is helpful for early investors who may want liquidity prior to the sale of the company or an IPO.  Assuming the Series B is sold at $2 per share and the Series A was sold at $1 per share, the Series B investor typically would not want to pay $2 per share for a Series A stock with price-based rights (i.e. liquidation preference) at $1 per share.  Of course, allowing an exchange of stock with a lower liquidation preference to a stock with a higher (and potentially senior) liquidation preference is detrimental to the holders of common stock.

I have seen somewhat similar provisions in the past in a slightly different context. In early stage Series A financings, some investors have tried to eliminate certain provisions, such as registration rights, from the standard documents to decrease the complexity and length of typical financing documents. However, these investors want the benefit of rights given to future investors. For example, I have seen a term sheet provision that provides for “most favored nation” status.

When the company raises a Series B financing, the terms of the Series A shall be amended to be at least as favorable as those granted to the Series B.

The problem with this provision is that it is not precise enough.  For example, one might interpret this to mean that price-based provisions (such as liquidation preferences) would be upgraded.

As an alternative, I have used the following term sheet provision in seed stage Series A financings where the investors received a Series A preferred stock with a liquidation preference and no other rights.

If the Company grants registration rights, information rights, rights of first offer, price-based antidilution protection, protective voting provisions or other similar rights to new investors in a subsequent financing involving the sale of additional series of Preferred Stock, the Company will use reasonable efforts to extend such rights to the Purchasers on the same basis granted to new investors. The Company also agrees to use reasonable efforts to provide that holders of greater than 400,000 shares of Preferred Stock will receive any rights customarily having minimum stockholding requirements.

In any event, I wouldn’t be surprised if more sophisticated early-stage investors that want to sell their stock prior to a sale of company or IPO started started asking for “upgradeable” preferred stock.

How do the sample Y Combinator Series AA financing documents differ from typical Series A financing documents (or what’s the difference between seed and venture financing terms)?

By 7 Comments

Y Combinator recently published forms of Series AA equity financing documents that YC portfolio companies have used when raising angel financing.  YC provides a three month startup program for entrepreneurs twice a year in Cambridge, MA and Mountain View, CA.  YC typically provides $5K plus $5K per founder of seed funding for usually 6% of the equity in common stock (which, as an aside, Sarah Lacy seems to question, but in my mind seems like something that I would jump at if I were a fledgling entrepreneur).

[Disclaimer/disclosures:  Please read the disclaimer on the documents and on my website.  I write this blog in my personal capacity and my opinions may differ from my colleagues.  WSGR represents Y Combinator and many of its portfolio companies.  I represent a YC portfolio company that provides the Chatterous application and have worked with Y Combinator founder Trevor Blackwell’s company Anybots.  I have also represented investors that have invested in a couple of YC portfolio companies.  I may update this post in the future.]

I was planning to write a post on the differences between angel financing terms and venture capital financing terms, and thought that the YC documents provided a good opportunity to explain the differences.  I’ve already noticed some commentary about the documents and decided to provide some more detailed explanations and the situations that they might be used.

If you want to review annotated Series A venture capital financing documents, please review the NVCA model venture capital financing documents.  (Please note that I think that the default provisions in the NVCA documents are generally fairly investor-favorable and reflect east coast practice rather than Silicon Valley practice.  I will probably write a post about these documents at some point in the future.)  This post assumes that you have a basic understanding of Series A financing terms.  If you don’t, please educate yourself on this site, Venture Hacks and the term sheet series by Brad Feld/Jason Mendelson, among other places.

What situations should these documents be used in?

The YC documents are probably fine in situations where the investor (i) wishes to purchase equity rather than convertible debt, (ii) is otherwise somewhat indifferent on terms other than percentage ownership of the company, liquidation preference and right of first offer in future financings, (iii) is investing at a fairly low valuation (i.e. a couple of million dollars), and (iv) is only investing a small amount (i.e. a couple hundred thousand dollars or less).

In my experience, sophisticated angel investors expect to receive a full set of Series A documents with rights essentially the same as venture capital investors, so the Series AA documents may not be acceptable in these situations.  I think these documents are most appropriate in a friends and family equity seed financing.  However, I believe that companies are generally better off with convertible debt rather than an equity financing at a low valuation.

Why is it called Series AA?

To differentiate it from typical “Series A” preferred stock, which comes with certain expectations with regard to rights.  I’ve had clients rename their Series A, B and C to Series A-1, Series A-2 and Series A-3, so that their first institutional venture capital financing was called the Series B.  There is no real rule to what a particular series of preferred stock is called (i.e. Series FF for the Founders Fund invention).  I suppose that YC could have named it Series YC, instead of Series AA, for better branding.

What rights does the Series AA have in the sample YC documents?

Obviously, please read the term sheet. The primary rights in these documents, ranked in order of importance in my opinion are:

  • Right of first offer on future financings.  Please note that these documents provide that the right of first offer expires five years after the financing, which I believe is not standard (but happens to be the company-friendly default in the WSGR form of documents that the Series AA documents were based on).
  • Information rights.  The investor receives unaudited annual and quarterly financial statements.

There are situations where an investor might receive stock with even less rights.  For example, if a founder contributes a significant amount of cash (i.e. enough to buy a car) to fund the company, then I might suggest that the company issue preferred stock with a liquidation preference and no other rights to the founder, as opposed to issuing common stock.  The reason for issuing preferred stock instead of common stock is to preserve a low common stock value for option grants as explained in this post, and providing the stock with a liquidation preference.

What are the primary rights that are missing from the these documents that a VC or sophisticated angel would expect?

Some people have suggested that various terms are unnecessary in early stage Series A financings.  See the VentureBeat article titled “Reinventing the Series A.”  In the sample YC documents, there are various terms that are missing that one would typically expect in a company-friendly Series A term sheet (i.e. one from Sequoia Capital).

  • Dividend preference.  Deleting the dividend preference is not a big deal, as almost all startup companies don’t declare dividends.  The only practical situation that I can think of where a dividend preference is beneficial to a stockholder is where a company does a partial sale of assets and wishes to distribute the proceeds to stockholders. The liquidation preference would not apply in this situation, and any distribution to stockholders would trigger the dividend preference.
  • Registration rights.  As a practical matter, I don’t think that most investors should really care about registration rights, especially in light of the shortening of the Rule 144 holding period to 6 months.  (I suppose I will write a boring post about Rule 144 at some point.)
  • Anti-dilution protection.  Deleting anti-dilution rights saves several pages of text in the Certificate of Incorporation. Given that the Series AA is issued at a fairly low valuation, anti-dilution protection is probably not that important, as a “down round” from a low valuation in the Series AA is unlikely.
  • Comprehensive protective provisions.  The YC documents are fairly light on protective provisions compared to a typical Series A financing.
  • Right of first refusal and co-sale.  These rights are missing.  This is probably okay assuming that the founders restricted stock purchase agreement has a right of first refusal on transfers until a liquidity event.  The right of first refusal on founder stock transfers in a typical restricted stock purchase agreement is in favor of the company.  (Please note that when I say typical, I mean an agreement drafted by attorneys experienced in venture financings, not the boilerplate you might get from an online incorporation service.)  The typical RFR/co-sale agreement in a venture financing gives the investors a right to purchase the shares if the company does not exercise its right.
  • Voting agreement.  An optional bracketed provision in the Certificate of Incorporation provides for a Series AA board seat.  In a typical venture financing, there would also be a voting agreement that governs how specific board seats will be filled.  In angel financings, I typically eliminate the voting agreement anyway and simply have a closing condition that the board consist of certain persons.
  • Comprehensive representations and warranties.  The Series AA Preferred Stock Purchase Agreement has fairly limited reps and warranties.  As a practical matter, investors don’t sue companies for a breach of reps and warranties, so reps and warrants basically serve to flush out diligence issues.  In an early stage company, extensive reps and warranties are probably unnecessary.
  • Legal opinion.  A company counsel legal opinion is missing in these documents.  A legal opinion for a newly-incorporated early stage company probably doesn’t add much to the due diligence process and is probably unnecessary compared to the incremental cost to prepare.
  • Legal fees.  Each side pays its own legal fees in these documents.  Venture funds expect the company to pay investor counsel fees.

Do I need an attorney to help me complete a financing if I have these documents?

Yes.  Absolutely.  These documents are not intended to be “fill in the company name,” sign the docs and collect checks/wire transfers.  The fact that certain rights were intentionally omitted from the documents compared to typical VC financing documents is a judgment call that requires the guidance of an experienced attorney. There are always various corporate housekeeping matters that need to be cleaned up in connection with a financing.  Please don’t try to use the YC documents without working with a competent attorney.

What does fully-diluted capitalization mean?

By 3 Comments

“Fully-diluted” capitalization typically includes (1) all outstanding common stock, (2) all outstanding preferred stock (on a converted to common basis), (3) outstanding warrants (on an as exercised and as converted to common basis), (4) outstanding options, (5) options reserved for future grant, and (6) any other convertible securities on an as converted to common basis.

The concept is what number of shares is already “spoken for.”

Authorized, but unissued stock, is not counted in the fully-diluted capitalization number.

What is Form D and what information gets publicly disclosed to the SEC regarding a financing?

By 5 Comments

The SEC adopted new rules regarding Form D, which is routinely filed by companies for venture financings relying on one of the securities exemptions under Regulation D of the Securities Act. Regulation D is a exemption from the onerous registration requirements (i.e. a Form S-1 registration statement) of the Securities Act for a private placement of securities.

Form D is currently filed in paper format and must be filed within 15 days of the first sale of securities in the offering. Paper filings can be accessed through the SEC public reference room, and some third-party services provide information on Form Ds by scanning the paper filings. Some publications covering private company financings routinely monitor information on Form D filings from these third-party services, and often announce details of venture financings discovered in Form D filings.

Effective March 15, 2009, the old paper version of Form D will be eliminated, and electronic filing of the new version of Form D will be mandatory. The SEC’s new online filing system for Form D is expected to be available September 15, 2008, after which there will be a six-month transition period during which companies will have three options for filing a Form D: (i) filing the old version of Form D on paper; (ii) filing the new version of Form D on paper or (iii) filing the new version of Form D electronically.

Once Form Ds are filed electronically under the new rules, they will be available to anyone via the SEC’s EDGAR website.  Start-up companies that are operating in “stealth” mode or have otherwise made no public announcement of their financings should be aware that Form Ds will be more readily available once electronic filing becomes mandatory. Thus, some venture funds have requested that company counsel in venture financings avoid filing Form Ds.

Failure to file a Form D complicates the ability of the company to comply with state securities laws.  Unfortunately, one of the benefits of filing a Form D and complying with Regulation D is that the company does not need to separately comply with a securities law exemption in each state where the securities are offered. Compliance in each state requires company counsel to confirm that an exemption is available, which may increase costs in a financing if offers are made in multiple states. In addition, exemptions may not be available in certain states based on the fact pattern unless the offering also complies with Regulation D. Thus, any decision to affirmatively avoid a Form D filing should be carefully discussed with counsel.

Please refer to the existing version of Form D for the information that must be disclosed.  Among other things, the amount of the financing, the names of executive officers and directors, and the names of 10% stockholders must be disclosed.  The new rules eliminate some of the disclosure required by the current version of Form D. In particular, companies will no longer be required to identify 10% stockholders by name, or to provide detailed information on the use of offering proceeds. The new Form D will require some new disclosure in other areas, however, including a requirement to provide information on the recipients of sales commissions or finders fees.  In addition, the new rules also clarify when amendments to Form D are required.

[Update:  PEHub, which regularly uses Form D filings to report on venture financing, notes that the new rules require less information that the old rules, and that they will not cite information from the revised form without corroboration.]

What is par value?

By 10 Comments

Par value is the minimum price per share that shares must be issued for in order to be fully paid. I typically recommend that par value be set at $0.001 or $0.0001 per share.  Thus, if a founder purchases 8,000,000 shares of common stock, the minimum price that the founder has to pay is $8,000 at $0.001 per share or $800 at $0.0001 per share.  Par value can even be set lower, such as $0.00001 per share, in order to minimize the amount paid for founders.  Some states, like California, allow for no par value shares.

What is the California Finance Lenders Law?

By 1 Comment

Under the California Finance Lenders Law (the “CFLL”), a person engaged “in the business of a finance lender or broker” within California generally must obtain a license from the California Department of Corporations.  The law provides a number of exemptions from this requirement, including exemptions available for small business investment companies and persons that limit their lending activities to no more than one loan in any 12-month period.

However, the licensing requirements of the CFLL are not triggered by a qualified bridge loan (“QBL”), which is defined as a “commercial bridge loan” made by a “venture capital company” to an “operating company.”  Thus, a venture capital fund that made only QBLs would not be required to obtain a license under the CFLL.  However, a fund that makes other types of loans should be subject to licensing requirements only if those loans cause the fund to be engaged in the business of a finance lender or broker.

In general, a “commercial bridge loan” is any loan that: 

1.         Has a principal amount of $5,000 or more;

2.         The proceeds of which are intended to be used by the borrower other than for personal, family or household purposes;

3.         Matures in one year or less;

4.         Is made in connection with, or in contemplation of, an equity investment in the borrower;

5.         Is secured, if at all, solely by the borrower’s business assets (but not by real property); and

6.         Is subject to the implied covenant of good faith and fair dealing arising under Section 1655 of the California Civil Code.

A venture capital fund generally will be a “venture capital company” if it: 

1.         Engages primarily in the business of promoting economic, business, or industrial development through “venture capital investments” or the provision of financial or management assistance to operating companies;

2.         At all times maintains at least 50 percent of its assets in venture capital investments or commitments to make venture capital investments;

3.         Maintains or, assuming consummation of the equity investment to which a commercial bridge loan relates, will maintain a material equity interest in the borrower;

4.         Approves each loan made to an operating company through the fund’s board of directors, executive committee, or similar policy body, based on a reasonable belief that the loan is appropriate for the operating company after reasonable inquiry concerning the operating company’s financing objectives and financial situation; and

5.         Complies, when making the loan, with all applicable federal and state securities laws.

A “venture capital investment” is “an acquisition of securities in an operating company that a person, an investment adviser of the person, or an affiliated person of either, has or obtains management rights to.”  The statute provides no definition of the term “management rights,” but the term is well defined in other places.  The first is the definition of “venture capital operating company” under the Employee Retirement Income Security Act of 1974 (“ERISA”).  The second is Rule 260.204.9 of the California Code of Regulations, which deals with the regulation of investment advisors.

In general, a borrower is an “operating company” if it: 

1.         Engages (directly or through subsidiaries) in the production or sale, or the research or development, of a product or service other than the management or investment of capital;

2.         Uses all of the bridge loan proceeds for the operations of its business; and

3.         Approves the bridge loan through its board of directors, executive committee, or similar policy board, based on a reasonable belief that the loan is appropriate for the borrower after reasonable inquiry concerning the borrower’s financing objectives and financial situation.

What are directors’ duties and what can they do to protect themselves in a sale of company?

By 1 Comment

[The following post is courtesy of Priya Cherian Huskins, Esq., a partner and senior vice president at Woodruff-Sawyer & Co., an insurance brokerage headquartered in San Francisco, California.  Priya specializes in director and officer liability and its mitigation through both insurance and corporate governance solutions.  This article was first published in the 2008 edition of Boardroom Briefings: Mergers and Acquisitions, and has been republished here with Priya’s permission.  Priya was previously an attorney at WSGR.]

Consider this scenario: a company’s CEO tells his board that he has received a compelling offer for the sale of the company.  Upon reviewing the offer, the directors agree that the offer is attractive, and think that the shareholders would be well-served to accept the offer.  However, as experienced board members, they know that the potential sale of a company is an inflection point for litigation.  After all, 24% of securities class action law suits include merger-and-acquisition-related allegations[1], and shareholders often bring breach-of-fiduciary duty suits in connection with M&A activities.

The board’s next steps are critical, both to maximize shareholder value and to avoid litigation that may result from failing to do so.  This article outlines the fundamental duties of a board considering the sale of a company.  The article also details what a board can do – beyond diligently fulfilling its duties – to protect itself from liability and thereby focus entirely on promoting the interest of shareholders.

What Are a Director’s Duties under the Law?

When it comes to directors’ duties, it is always useful to think in terms of the golden triad of the duties (1) care, (2) loyalty, and (3) appropriate disclosure.  As is the case in other situations that call for director action, this triad provides a useful framework for thinking about the sale of a company.

1.  Duty of Care.  The duty of care requires that directors diligently pursue the interests of the shareholders who elected them.  Consistent with this duty, and articulated in the well-known Revlon[2] case and its progeny, once a company is up for sale directors of the company must “undertake reasonable efforts to secure the highest price realistically achievable given the market for the company.”[3]

If the board’s efforts are subsequently challenged, the court will review the process set up by the directors for reasonableness.  This is a tougher standard of review than the usual “bare rationality” standard that courts apply to other board decisions, referred to commonly as the business judgment rule.  As one Delaware Chancery Court opinion described it, “this reasonableness review is more searching than [the business judgment rule’s] rationality review, and there is less tolerance for slack by the directors [emphasis added].”[4]

Recognizing that one size will not fit all, Delaware courts have declined to provide boards with the comfort of a “judicially prescribed checklist of sales activities.”[5] Instead, directors must use sound business judgment to construct a deliberate, systematic sale process reasonably designed to maximize shareholder value.

One sale process that most would agree is designed to maximize shareholder value is to conduct an auction of a company.  There is, however, no requirement to conduct an auction of the company.  In the June 2007 Delaware Chancery Court decision concerning the sale of the baseball card maker Topps Company, Inc., the Court noted that in light of a failed auction attempt two years earlier there was no need for the company to conduct an auction when it decided to sell itself.  The Court ruled this way in part because Topps did not have a poison pill in place that would otherwise discourage other buyers from approaching the company.[6]

Nevertheless, companies should be on guard against prematurely cutting off alternative buyers.  Consider, for example, the proposed sale of Netsmart Technologies, Inc.  In its March 2007 decision concerning that company’s sale process, the Delaware Chancery Court was unimpressed by the board’s consideration of only private equity buyers.  The Chancery Court took special note of the board’s failure to consider strategic buyers when it decided to sell the company.  In the words of the Chancery Court “it was incumbent upon the board to make a reasonable effort to maximize the return to Netsmart’s investors. On the existing record [which supports no serious consideration of strategic buyers], I cannot conclude that their approach to this issue is indicative of such an effort.”[7]

Part of a board’s ability to put together a reasonable sale process will depend on the board’s familiarity with a variety of sophisticated deal-protection devices such as no-shop provisions, break-up or termination fees, matching or topping rights, and the like.  In addition to understanding the mechanics of these types of provisions, a board must also understand the impact these types of provisions will have on the board’s ability to maximize value for its shareholders.

This is an area where the board is well-served by seeking advice from independent litigation counsel and having its discussions with counsel protected by the attorney-client privilege.  Consistent with the public policy that supports attorney-client privilege, a board will want an opportunity to freely ask questions about the proposed transaction and to debate the merits of the deal.  The possibility of future litigation can chill this kind of back and forth.  Directors may fear that in future litigation their genuine and sincere questions will be misconstrued as evidence of nefarious intent.  In light of all of this concern, the board should ask outside counsel specific questions about how to protect the privilege, and then to follow the protocol outside counsel recommends.

Finally, in addition to having a good sale process, a board is well-served by documenting its sale process in a timely and diligent manner.  A too-casual approach can result in few formal meeting minutes or worse still the exercise of approving minutes after litigation has commenced.  The board will not want to appear casual if it finds itself in the midst of hotly contested litigation over the adequacy and diligence of its efforts.

2.  Duty of Loyalty.  The duty of loyalty requires that directors act in an independent manner and with regard only to the concerns of the shareholders.  In the context of the sale of company, it is inappropriate to favor one buyer over another for reasons other than the maximization of shareholder value.

One way to violate the duty of loyalty is to give preferential treatment to a buyer that plans to keep current management and/or board members around after the sale has closed.  The possibility that a potential buyer was treated more favorably by management due to promises made to keep management in place post-closing was exactly the conflict of interest issue that was brought to the Delaware Chancery court’s attention in the earlier-described Topps transaction.  In reviewing the facts of the case, the Chancery Court found that the bid of a potential acquirer that would likely have replaced management was treated less favorably compared to the treatment accorded another bidder that had promised to retain management.[8] This was part of the reason that the Court was unwilling to allow the merger vote to move forward without giving the badly treated potential buyer an opportunity to communicate directly with Topps’ shareholders.

Forming a Special Committee of the board composed of outside directors to drive the sale process is a way to mitigate the potential conflict-of-interest issues with respect to incumbent management.  If the board decides to go in this direction, the board should form the Special Committee sooner rather than later to get the maximum benefit of the Committee.  One decision early in the process that is best undertaken by a Special Committee-and not management-is the scope of the types of offers and buyers the board will entertain.[9]

The Special Committee should avoid delegating too much authority to any member of the management team who has a conflict of interest.  Doing so considerably weakens the protection that the formation of a Special Committee can offer.  In its June 2007 decision concerning the sale of the Lear Corporation, the Delaware Chancery Court specifically addressed the issue of putting in charge of negotiations a CEO who had a clear personal interest in having a sale consummated.  Although the Court ultimately decided that there was no evidence that putting this CEO in charge of negotiating this particular sale “adversely affected the overall reasonableness of the board’s efforts to secure the highest possible value,” the court still referred to the Special Committee’s decision in this matter as ” infelicitous.”[10] In other words, the Special Committee got lucky with the Court’s “no harm, no foul” ruling.

3.  Appropriate Disclosure.  It is uncontroversial that directors have a duty to disclose to shareholders all information that is material to a shareholder’s decision to vote on the sale of a company.[11] More specifically, directors are required to disclose balanced, truthful, and materially complete information.[12] In the heat of a sale transaction, it can be all too easy for management and boards to neglect to adhere fully to this requirement.

This was an issue raised in the 2007 Netsmart Technology decision.  The board and management’s failure in this regard caused the court to require the company to provide more information to shareholders prior to holding a vote on a proposed merger. Specifically, the Chancery Court wanted to make sure that the shareholders had a chance to review the discounted cash flow analysis that the company’s investment bankers prepared because the shareholders were being asked to rely on a fairness opinion that itself relied on these projections.  In the words of the court, “[o]nce a board broaches a topic in its disclosures, a duty attaches to provide information that is materially complete and unbiased by the omission of material facts.”[13]

What Else Can Directors Do to Protect Themselves?

Even the best board with a laser-like focus on its duties of care, loyalty and disclosure may find itself the target of a suit brought by disgruntled shareholders or perhaps a disgruntled bidder.  A board’s concern over such suits can result in excessive caution, which is not in the best interest of shareholders.  Consequently, the natural next question is “what can board members do to protect themselves from personal liability?”

First and foremost – and well before any potential sale event – directors should update their personal indemnification agreements with their companies.  Rather than rely on a contract that may be many years old, directors should ask someone who represents the board to review the indemnification agreement to ensure that they have the most protective language possible.  This review should pay special attention to change-of-control provisions.  For example, indemnification agreements should expressly require an acquiring company to assume the selling company’s indemnification obligations in writing.  This exercise of updating the board’s indemnification agreements ultimately inures to the benefit of the company’s shareholders by allowing the directors to put concerns of personal liability aside and focus instead on the business at hand.  It is also consistent with public policy position expressed by Delaware corporate law.  Delaware’s corporate law allows companies to protect their directors with expansive indemnification protections.

Next, and again well before any potential sales event, directors should confirm that their D&O insurance policies are well-designed.  If there has not been an independent check of the D&O policies for a number of years, conduct one.  D&O policies are highly technical contracts, and can be properly analyzed only by an expert in the field.  Among the provisions that should be analyzed are the change-of-control provisions, as well as provisions that prevent the knowledge and acts of another person – an officer, for example – from being attributed to a board member to his or her detriment.

Finally, when a company is ultimately acquired, the company’s board will want to make sure that a “tail policy” is purchased for the acquired company’s D&O insurance policy.  Typically six years in duration, a tail policy holds open the acquired company’s current D&O policy so that it will respond to new claims that are made against the acquired company’s directors after the sales transaction has closed.  The directors of the acquired company may not be in a position to demand protection from the acquiring company after the sale is closed.  Consequently, it is essential that the board of the selling company put this protection in place before the sale is consummated.  One way to do this is to have the directors’ personal indemnification agreements include the right to a tail policy should the company be acquired.

Serving Your Shareholders, Protecting Yourself.  In summary, the sale of a company is a high stakes event for shareholders, management, and directors.  The role of the board is to seek an outcome that is the best available to the shareholders.  To meet the demands of this role, directors must understand what is required with respect to the duties of (1) care, (2) loyalty, and (3) appropriate disclosure.  In exercising their duties, shareholders are not served when directors act with excessive caution.  Instead, shareholders are best served when directors can exercise judgment that is unclouded by the concern that, notwithstanding their good faith efforts, they will be faced with a shareholder suit.  To alleviate this concern, directors should take proactive steps before a sale is even on the horizon to obtain state-of-art indemnification agreements and D&O insurance policies.  With advance planning, a board will be well positioned to handle a sale in a way that effectively and properly promotes the interests of shareholders.

[1] Woodruff-Sawyer & Co. Proprietary Securities Class Action Litigation Database.

[2] Revlon, Inc. v. MacAndrew & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1985).

[3] In re Netsmart Technologies, Inc. Shareholder Litigation, 2007 WL 1576151 (Del. Ch.).

[4] Netsmart at *15.

[5] Ibid.

[6] In re The Topps Company Shareholder Litigation, 2007 WL 1732586 (Del. Ch.) at 50.

[7] Netsmart at *18.

[8] Topps at 61 and 62.

[9] Netsmart at *21.

[10] In re Lear Corporation Shareholder Litigation, 2007 WL 1732588 (Del. Ch.).

[11] Arnold v. Society for Savings Bancorp., Inc., 650 A.2d 1270, 1277 (Del. 1994).

[12] Netsmart at *21

[13] Netsmart at *24.

Filed Under: M&A

What is important in a confidentiality agreement or non-disclosure agreement (NDA)?

By 16 Comments

There are various factors to consider when reviewing or drafting a confidentiality or non-disclosure agreement (NDA). Obviously, your perspective on the agreement depends on whether you are primarily disclosing or receiving confidential information. The following points should be kept in mind:

  • Need for an agreement. Entering into an NDA increases the risk that the recipient may face charges of trade secret misappropriation if it develops similar information in the future or inadvertently discloses or uses the information. This is the primary reason that VCs will not enter into NDAs.
  • Mutual versus one-way. Some agreements only cover disclosure of confidential information by one party. Other agreements are mutual and cover disclosures by both parties. Generally speaking, mutual agreements are less likely to have provisions that are one-sided.
  • Non-disclosure and non-use. There are two important restrictions in an NDA. The non-disclosure provision prevents the recipient from disclosing the confidential information to third parties. The non-use provision prevents the recipient from using the information other than for a specified purpose. Occasionally, an NDA may not have a non-use provision. This would allow the receiving party to use the information for its own purposes as long as it did not disclose the information
  • Definition of confidential information. The discloser will want a broad definition of confidential information and may also want third party confidential information to be deemed confidential. The receiver will want to narrow the definition of confidential information in order to avoid being “tainted” by the information. The definition can be narrowed by (i) limiting it to information disclosed in writing (or oral disclosures reduced to writing within a certain time frame), (ii) specifically marking the information confidential, (iii) specifying the information that is deemed confidential or (iv) specifying the dates of disclosure. The discloser will want to avoid some of the limitations because of the possibility or inadvertent disclosure or over-marking information as confidential, which may impair the ability to enforce the agreement with respect to genuine trade secrets.
  • Exceptions to confidential information. The recipient will want broad exceptions to the definition of confidential information. Typical exceptions to the definition of confidential information include (i) information publicly known or in the public domain prior to the time of disclosure, (ii) information publicly known and made generally available after disclosure through no action or inaction of the recipient, (ii) information already in the possession of recipient, without confidentiality restrictions, (iv) information obtained by the receiver from a third party without a breach of confidentiality, and (v) information independently developed by the recipient. The discloser will try to limit the exceptions or add qualifiers such as the discloser must prove the exception with contemporaneous written records. Please note that the typical exception for information required to be disclosed by law should be an exception to the duty to not disclose, as opposed to an exception from the definition of confidential information (which would allow the recipient to disclose the information to anyone).
  • Residual information. The recipient will want to include a clause that allows the recipient to use the discloser’s information that is retained in its employees’ memory. The recipient will want to avoid being “tainted” by receiving the information. This is often strongly rejected by the discloser. In the event the residuals clause is included, the discloser may try to limit it to (i) use of general skills and knowledge, (ii) information retained in the unaided memory of employees after a certain amount of time after access to the confidential information, and (iii) explicitly noting that the discloser is not granting any license to the recipient.
  • Permitted disclosures. The discloser will want to limit disclosures to employees and contractors on a need to know basis with similar non-disclosure obligations. In addition, if disclosure is required by law, the discloser will want the recipient to notify the discloser in advance and provide the opportunity to obtain a protective order or otherwise maintain the confidentiality of the information.
  • Term. NDAs commonly have terms of three to five years. The period of time depends the strategic value of the information to the discloser and how quickly the information may become obsolete.