Flawed, but Fair: Updated Guidance for Boards and Investors

A recent Delaware decision, in re Trados Incorporated Shareholder Litigation [1], underscores a director’s responsibilities in “underwater” venture deals. In a 114-page opinion by Vice Chancellor Laster, the court reviewed the sale of Trados Incorporated, whose common stockholders received nothing in the sale of the company after the proceeds were absorbed by preferred stock liquidation preferences and a management incentive plan. Applying an entire fairness analysis, the court held in favor of the defendant directors, finding that, while the sale process was deficient in several ways, the common stock had no economic value and thus no expectation to any proceeds. However, the court was critical of the process employed by the directors and management and, if the common stock of the company had not been valueless, the decision could easily have gone the other way. Friends and clients facing the challenge of maximizing the value of a venture-backed company in which the liquidation preferences of preferred stock outstrip the value of the common should pay particular attention to this case.

Background

The facts of this case should sound familiar to anyone who has been involved in the sale of venture-backed company.

Trados successfully developed and produced language translation software for desktop computing systems. After multiple rounds of investment, Trados’s venture capital (VC) investors held a majority of the company’s voting stock, in the form of convertible preferred shares, and were entitled to designate four of the seven directors on the board.

Trados performed well, but not at a rate that the VCs thought would generate any meaningful level of return on their investments, and the VC-nominated directors began to explore a near-term exit. The board replaced the CEO with one who had M&A process experience, engaged a financial advisor, and established a management incentive plan (MIP), directing a portion of the proceeds of a sale to management.

After initially rejecting an inferior proposal, Trados agreed to be acquired by a strategic buyer. Of the $60 million of aggregate sale proceeds, $7.8 million was distributed to management under the MIP, with the remaining $52.2 million distributed to the VC investors, whose liquidation preference was at that time $57.9 million. Nothing remained of the sale proceeds for the common stockholders. The plaintiff, who owned approximately 5% of the company’s common shares, sued, alleging that the directors had breached their fiduciary duty in approving the sale.  

The Court’s Opinion

Directors were Conflicted

In evaluating the board’s actions, the court, having found that six of Trados’s seven directors were neither disinterested nor independent, applied Delaware’s “entire fairness” standard of review, which considers separately both the sale process and sale price and is a steep burden for defendants to overcome. 

The court found that three of the directors who were fiduciaries of the VC funds had inherent conflicts of interest. The CEO and CFO, who also were on the board, were conflicted because they stood to receive material compensation under the MIP and were to be employed by the buyer after the sale.

The remaining conflicted director lacked independence because he had past and present business relationships with one of the VC funds. According to the court, it is rare for independent directors on the boards of VC-backed entities to ever be truly independent, due to their “web of interrelationships.”[2]

Process Ignored the Common Stockholders

In addition to the board conflicts, the sale process was flawed in two ways: (1) the board failed to properly consider the interests of the common stockholders; and (2) the MIP improperly allocated deal consideration to management at the expense of the common stockholders.

According to the court, the directors “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.”[3]  The record lacked discussions of alternatives to the transaction, and showed instead that the directors were interested only in pursuing the sale process and not in continuing to manage the company as a going concern.

The court also criticized the MIP. Its effect was to remove the value to management of its own common stock while simultaneously disincentivizing management to consider common stockholder interests more generally. After the MIP was funded, the preferred stockholders received 90% of their liquidation preference in the sale and the common stockholders received nothing.  In the court's view, the board did not sufficiently explore different ways to allocate the deal proceeds in the context of the deal in front of them. 

Valuation Trumps in this Case

In spite of the procedural flaws, the court agreed with the defendants that the common stock of Trados had no economic value at the time of the sale. While the company was performing well, the court saw no likelihood that Trados would be able to grow at a rate that would generate a return “sufficient to escape the gravitational pull of the large liquidation preference” and an 8% cumulative dividend. The Trados directors were, accordingly, absolved of any breach of their fiduciary duties.  Nevertheless, it is easy to envision a different value conclusion by the court and a consequent finding against the directors.

Key Lessons and Observations

• Preferred stockholders, and particularly VC firms, are likely to see their interests diverge from those of common stockholders in the case of a mixed success company and substantial liquidation preferences.  Where these interests diverge, the board’s duty is first and foremost to the common stockholders. The Trados court notes that boards do not owe fiduciary duties to preferred holders with respect to their special rights and preferences because they are contractual in nature.
• When a company’s success has been mixed and there is little current value in the common stock, preferred stockholders may favor earlier exits over strategies that could result in greater long-term value, but which also risk decreasing existing value (since that risk is disproportionately borne by the preferred). On the other hand, common stockholders standing to recover relatively little or no value in a sale will unsurprisingly tend to prefer longer-term growth strategies. For this reason, a growing trend is for company founders to explore different organizational structures (particularly inside limited liability companies) designed to balance the economic interests of the parties.
• Prior to undertaking the sale process, companies should consider adding truly disinterested, independent directors to their board. This would enable either a majority of the board to act without conflict or the board to appoint an independent committee to analyze the transaction. Doing so could shift the burden of proof to the plaintiffs that the transaction was not entirely fair, an important procedural advantage for defendant directors. A board could also engage an outside advisor to provide a fairness opinion or seek the approval of a majority of the disinterested stockholders. These mitigating actions, however, often are not possible under the circumstances, or are too costly.  In those cases, boards should be prepared for the process they undertake to receive the heightened scrutiny of the entire fairness standard.  
• One of the difficulties faced by the Trados directors was that the corporate records were devoid of documented discussions and the court found after-the-fact director testimony regarding discussions unpersuasive. Directors considering a sale process should be diligent in memorializing what was actually discussed and considered at meetings and have minutes prepared or reviewed by counsel. 
• Directors should be thoughtful about structuring management incentive plans that may later be interpreted as an incentive for management to pursue a sale at the expense of the common. In Trados, the MIP was problematic both for its disproportionate impact on consideration to the common stockholders (complete loss), and the fact that management’s interest in its common holdings was negated by its interest under the MIP.
• It is possible under certain state statutes to explicitly alter a board’s fiduciary obligations in a company’s formation documents. For example, in the articles of incorporation, it may be possible to permit advance delegation of approval responsibility for a sale transaction to preferred stockholders. Of course, common stockholders and founders may object to such a delegation and the enforceability of it is also uncertain.[4]

Conclusion

The Trados decision highlights some of the pitfalls confronting VCs and their affiliated directors when evaluating paths to exit mixed-success investments. In such cases, the risks created by conflicting interests can best be mitigated, even if not altogether eliminated, when boards recognize those conflicts and take (and document) steps to ensure that the interests of the common stockholders are acknowledged and given due consideration in the process. 

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[1] C.A. No. 1512-VCL (Del. Ch. Aug. 16, 2013) (slip op.)

[2] Slip op. at 66

[3] Slip op. at 81

[4] We note that, regarding sale rights, the National Venture Capital Association, in response to Trados, has modified its Model Voting Rights Agreement to provide for certain holders of preferred stock to have the ability to cause the company to initiate a sales process. Further, in the event that a potential sale is identified, but not approved by the board, the preferred stockholders would have a right to put their shares to the company at the price that would have been obtained in the proposed sale.