If there is one truism in corporate governance, it’s that “one size does not fit all.” As highlighted by Stanford GSB Professor David Larcker and Brian Tayan in their article “Loosey-Goosey Governance,” the understanding of governance suffers from at least two problems: 1) the tendency to overgeneralize across companies — to advocate common solutions without regard to size, industry, or geography, and without understanding how situational differences influence correct choices; and 2) the tendency to refer to central concepts or terminology without first defining them.
As I’ve written in prior posts on startup governance and venture-backed company governance, there is still a widespread misunderstanding and under-appreciation of the scope of fiduciary duties owed by directors in U.S. venture-backed startups.
This is particularly worrying within the ranks of directors, which include VCs (often the most experienced directors since they are repeat players and sit on many boards, sometimes too many), founders (who tend to be younger, and the least knowledgeable on governance issues), executives (many times brought in as “adult supervision” by the VCs) and outside directors (some of whom may be experienced as directors of public companies, but who don’t necessarily understand the intricacies and nuances of the private venture capital market).
Some argue that this phenomenon may due to the lack of formal training/education to serve as a director, the lack of research on this topic or simply due to the fact that there is not as much accountability in private startups as compared to public companies (whether from regulators such as the S.E.C. or the plaintiff bar due to litigation economics).
Historically, the stakes of venture-backed companies have been relatively small. However, with the rise of private markets, record venture capital (VC) investments and a growing “unicorn” class, the disregard of Delaware case law by startup directors is surprising, particularly since the economic (and social) impact of VC is greater than ever.
More evidence around the fuzziness of these duties is found in an excellent new study by Professor Abraham Cable from U.C. Hastings entitled “Does Trados Matter?” In his article, Prof. Cable interviewed 20 “startup lawyers” in Silicon Valley on whether the Trados case affected how they document VC financings or advise boards on exit transactions.
But first, let me explain the Trados case (which should be required reading for all directors of venture-backed companies).
Summary of the Trados case
Trados is a seminal opinion by the Delaware Chancery Court from 2013 that involved a common fact pattern in Silicon Valley: the sale of a venture-backed company (in this case for $60 million) where:
- The VC firms held a majority of the preferred stock, and were entitled to designate four of Trados’ seven directors. They received $52.2 million (less than their full $57.9 million liquidation preference);
- Members of management (executives hired by the board who had prior success in turning around and selling technology companies) received $7.8 million -equivalent to 13% of the merger consideration- under a management incentive plan (“MIP”).
- The common stockholders (including founders) received nothing.
The case is significant for the following reasons:
- Standard of Review: Imputing Conflicts of Interest to Directors.
The first question that the court had to decide in Trados was which standard of review to apply: the business judgment rule or the entire fairness standard.
- Business Judgment Rule (BJR): The court can use this deferential standard of review if, at the time the transaction is approved, the board acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company and its common stockholders. But in order to benefit from this presumption (and avoid being second-guessed by the court), the majority of the directors must have no conflicting interest in the decision.
- Entire Fairness Standard: Under this standard, the court goes through a “head counting” exercise. If a director-by-director analysis leaves insufficient disinterested and independent directors to make up a board majority, then the board cannot act as the qualified decision maker (and benefit from the BJR). Once entire fairness applies, the defendants must establish to the courts satisfaction that the transaction was the product of both fair dealing and fair price (exposing directors and VC funds to potentially extensive litigation and personal liability).
So, what happened in Trados? The court applied the entire fairness standard based on a review of the company’s seven directors. As in most venture-backed company boards, these directors can be divided into the following categories:
a) The VC Directors: Three of the directors in Trados represented VC firms. This made them conflicted because their preferred stock carried special rights that created specific economic incentives that differed from those of common stock. They were classic “dual fiduciaries” because they were wearing two hats: they owed a duty both to their VC fund (to maximize return on investment) and to the portfolio company (to maximize the value of the corporation for the benefit of the common stockholders). These directors were inherently divided in their loyalties, facing “competing duties” between their respective funds and the company.
The opinion also noted that interests of VCs may be aligned with common stockholders in highly successful companies where “everyboby wins” or in a total failure where “everybody loses,” but that their interests can diverge in “intermediate cases.” Some VC firms may strive to avoid these so-called “sideways situations”, also known as “zombie companies” or “the living dead” in which the entity is profitable and requires ongoing VC monitoring, but where the growth opportunities and prospects for exit are not high enough to generate an attractive internal rate of return. These companies “are routinely liquidated” usually via trade sales, “by venture capitalists hoping to turn to more promising ventures.” The evidence in Trados established that the VC directors faced these conflicts and acted consistent with their firm’s interest in exiting from Trados and moving on.
b) Management Directors: Two of the directors in Trados represented the common: the CEO and the President. However, both were interested in the transaction because they received personal benefits as a result of the MIP that were not equally shared by the common stockholders.
It is well-settled that a director “is considered interested when he will receive a personal financial benefit from a transaction that is not equally shared by the stockholders.” For purposes of fiduciary review, “the benefit received by the director and not shared with stockholders must be “of a sufficiently material importance, in the context of the director’s economic circumstances, as to have made it improbable that the director could perform her fiduciary duties… without being influenced by her overriding personal interest.”
Taken collectively, the Court held that the following benefits were material:
- The CEO received $2.34 million from the MIP “representing 23%–47% of his net worth at the time of the merger,” and the amount was “10x what he would make annually by continuing to manage Trados as a stand-alone entity.” The CEO also bargained for and obtained post-transaction employment at the acquiring company and became a member of its board, where he earned $60k per year for his service.
- The President received $1.092 million from the MIP (which he negotiated up from his original 12% to 14% after complaining about some strings attached to it such as his one year non-competition agreement). He also obtained post-transaction employment at the acquiring company.
Thus, the court held that these directors were conflicted: it was reasonable to think that their support of the deal could have been influenced by these material benefits.
c) Independent Directors: Having determined that the VC Directors and Management Directors were conflicted, the court then also imputed conflicts of interest to one of the so-called “independents.”
It turned out that this particular “independent” director: i) was nominated to the board by one of the VC firms, ii) had a long history with this VC firm (he had been a CEO of two of the VC firm’s portfolio companies), iii) had worked “very collaboratively” on other companies with the VC Director who was also on the board, iv) had invested about $300,000 as an LP in three of the VC’s funds, including the one that had Trados in its portfolio, v) at the time of the merger, he was the CEO of a company backed by this VC firm where the VC Director served on the board, and vi) he received shares in Trados through an acquisition of another company in which he was an investor, as was the conflicted VC firm.
The court found that his current and past relationships with the VC firm and the VC Director resulted in a sense of “owingness” that compromised his independence for purposes of determining the applicable standard of review.
It also didn’t help that he gave damning testimony. For example, he “inexplicably tried to deny that he was a VC designee before eventually conceding the point.” He tried to deny having any business relationships with the VC Director, despite the VC Director’s testimony about working together on a number of projects. And when asked if the VC Director’s position on his company’s board made him one of his bosses, “he contended that as CEO and Chairman, he reported to himself”.
In terms of his “interest” in the transaction, the director received $220,633 from the sale proceeds through a separate investment vehicle, which the court found to be material (“it represented nearly double his annual salary and 3.7%-5.5% of his estimated net worth”). Thus, he could not be counted as disinterested for purposes of determining the applicable standard of review.
Corollary: just calling someone an “independent director” doesn’t make them so!
All in all, 6 of the 7 directors were found to be conflicted.
2. The Court Asserted the Rule of the Common Maximization.
After concluding that the Trados board was conflicted, the court addressed the question to whom fiduciary duties are owed when the interests of common and preferred stockholders’ conflict. This is what academics call the “beneficiary question.”
In fact, prior to Trados, there had been debate over this question, with competing theories such as the rule of enterprise maximization (a board’s duty is to maximize the value of the entity, regardless of how proceeds will be distributed among shareholders) or the control-contingent approach (the fact that common holders ceded board control to preferred shareholders should be taken into account in evaluating fiduciary duty claims).
But in the Trados case, the court took into consideration these competing theories and emphatically endorsed the rule of common maximization: the board owes its primary duty to common stockholders when the interests of the preferred and common come into conflict.
The court held that directors owed a fiduciary duty to the common stockholders as the residual claimants (“the ultimate beneficiaries of the firm’s value”), not to preferred stockholders (who benefit instead from contractual protections).
The Trados’ board was criticized for failing to more vigilantly serve common stockholders, which is typical of Silicon Valley boards (that tend to be dominated and controlled by preferred investors).
Fundamentally, the court held that:
“The defendants in this case did not understand that their job was to maximize the value of the corporation for the benefit of the common stockholders, and they refused to recognize the conflicts they faced.”
The court explained the standard of conduct for directors:
“Generally it will be the duty of the board, where discretionary judgment is to be exercised, to prefer the interests of the common stock — as the good faith judgment of the board sees them to be — to the interests created by the special rights, preferences, etc. . . . of preferred stock.”
But despite the failure of the directors to follow a fair process and their improper focus on the preferred stockholders’ interests, the court concluded that the approval of the merger was fair to the common stockholders because the common had zero value at the time of the merger. The judge considered that Trados had no substantial prospects for a turnaround, so zero was a fair price for the common stock (even though he recognized that an unfair process could infect the price) but that based on the facts of the Trados case, such a finding was not warranted.
There are other important Delaware court cases that involve director fiduciary duties in venture-backed companies, such as Carsanaro v. Bloodhound Systems (2013), which settled for an undisclosed amount, Nine Systems (2014) and Basho (2018), where the same judge from Trados held that a VC investor and its director-designees exerted control in connection with a financing round and other post-financing actions in breach of their fiduciary duties. The court held the VC firm and its director-designees jointly and severally liable for $20.3 million in damages, including rescissory damages representing the difference between the value of the stockholder-plaintiffs’ shares before the financing transaction and the value of those shares at the time of the litigation.
So, what did Professor Cable find in his study?
Six years after Trados, Professor Cable observes the following:
“Trados has a modest but noticeable effect on their advice to clients. [The case does not appear to alter the customary terms of venture capital investments in startups] but interviewees report that Trados does affect the process of selling a startup. Most noticeably, boards are more systematic in assessing the value of continuing as a company. At the margins, Trados may even result in special allocations to common shareholders (payments to common shareholders in excess of their base entitlement).”
More interestingly, he reports that:
“the interviewees do not agree on whether Trados announced a new rule, and they do not converge on a single articulation of the applicable fiduciary standard.”
Wait, say that again? That’s right, from a sample of 20 startup lawyers in Silicon Valley, there is still a “general haziness around [the rule of] common maximization and its theoretical alternatives”. Even when “the court engaged with this academic debate and squarely endorsed common maximization in its opinion.”
No wonder directors are still in the dark!
What are the lessons for directors of venture-backed companies after Trados?
- Recognize That Most Venture-Backed Company Boards are Conflicted.
VC directors representing the preferred will likely be conflicted as dual fiduciaries. Management Directors may also be conflicted, particularly if they receive material benefits not available to the rest of the common stockholders. Independent directors may also be conflicted, depending on the facts of the case. Because of “the web of interrelationships that characterizes the Silicon Valley startup community”, scholars have argued that so-called “independent directors” on VC backed startup boards “are often not truly independent of the VCs.”
This means that most venture boards will not benefit from the business judgement rule. Instead, these cases will go into entire fairness reviews, a much higher threshold where the court will review the fairness of the process and the price of the transaction at issue.
However, there are preventable measures that a board can consider depending upon the context and specific facts surrounding a conflicted transaction. Some of these measures mostly involve creating a record showing fairness: rights offerings, market checks, fairness opinions, better board minutes, forming properly constituted special committees to approve conflicted transactions, or using a separate vote of the disinterested common stockholders, among other structural protections.
2. Directors Must Understand the Rule of Common Maximization.
To reiterate, per Delaware law, the board owes its primary duty to common stockholders when the interests of the preferred and common come into conflict.
When do these interests typically come into conflict? Mostly in cases involving 1) down-round financings (if the company raises funds by existing investors at a lower valuation than the previous round), 2) recapitalizations (raising at a lower valuation including reductions in liquidation preferences and/or reverse splits of the stock to reduce the equity ownership of existing investors) and 3) sales of the company (such as in the Trados case).
What if VCs invested in common stock instead of convertible preferred shares?
Historically, convertible preferred stock is the investment vehicle of choice for VCs. Preferred stock is distinct from common stock (which is what the founders and employees typically hold) in that it creates a new class of stock that has “preferred” economic and governance rights relative to common stock and other series of preferred stock. This way, VCs get both downside protection and upside potential (via an option to convert into common shares).
One way to avoid conflicts between preferred and common would be for VCs to invest in common stock instead. But this is an unlikely option (the whole VC industry is premised on convertible preferred stock, and there are powerful tax advantages to preferred stock), despite some founders such as Evan Spiegel at Snap reportedly conditioning investors to buy common stock at its later venture rounds (pre-IPO).
There is also a VC firm, Pillar VC, that is premised on this exact idea, which it labeled the common stock movement: “We launched Pillar in May 2016 with a focus on trying to align our interests as investors with the founders and teams we were backing. An important element of this effort was offering to buy Common Stock in companies. Why? Because we felt that the standard 10-page venture capital term sheet was riddled with terms and conditions that could cause misalignment among the parties, impacting trust and potentially compromising the performance of the investment.”
Others, such as Naval Ravikant and Babak Nivi, co-founders at Angel List, have suggested that this approach could be a clever strategy for investors to differentiate themselves and align with founders, a truly “founder-friendly” strategy.
What about Potential Founder Excesses?
Within the top echelon of tech unicorns, founders have been able to keep control of their companies. At least one study by The Information found the following:
“A third of the companies [from 30 prominent unicorns surveyed] have structured their boards so that more seats are elected by common stock than the preferred stock held by VC firms. Because founders typically hold common stock, this structure would allow founders to seat a majority of the board.”
Moreover, some founders have negotiated the power to cast more votes at board meetings, ensuring that they outvote other directors. Per the study, this is the case with Anne Wojcicki at 23andMe, who has the power to cast five votes at board meetings, ensuring that she can outvote the other four directors, and if the board increases in size, her board votes would rise to one vote more than the number of other directors). Ben Silberman at Pinterest and Evan Spiegel and Bobby Murphy at Snap had similar terms when their companies were private.
Then there is the issue of dual-class or supervoting shares, which gives founders and other insiders greater voting rights. This practice was introduced in Silicon Valley by Google’s IPO in 2004, and it has been fully embraced by leading tech companies ever since. One study found that there were 56 IPOs of tech companies with dual class shares between 2010 and 2016. But this is not only an issue for public companies. Per The Information’s survey cited above, “more than 40% of the [unicorns surveyed] have unequal voting rights among stockholders.”
In effect, the power-balance between founders and investors has changed in Silicon Valley since the mid-2000s, challenging the concept of the “founder’s dilemma.” Entrepreneurs had to make a choice between being “rich or king,” a trade-off between economics and control. But in today’s environment, particularly with the adoption of supervoting shares, founders have engineered a legal way to be both rich and king. This of course has created other problems, such as with Adam Neumann at WeWork or Elizabeth Holmes at Theranos. But those are whole different stories.
One size does not fit all indeed, and context matters in corporate governance.
Author: Evan M. Epstein
Founder & Managing Partner
Pacifica Global Corporate Governance
Pacifica Global was founded in San Francisco to serve as a leading corporate governance advisory firm. The mission of Pacifica Global is to help public and private companies solve some of their most complex corporate governance conflicts and challenges.