Sometimes the end game or sale of the company is not a happy event. Especially when outside investors, venture capitalists, or angels, have put in substantial money and the sales price is less than the value of their investment. Most all experienced VC and angel investors have found themselves in such a situation, since it is the unfortunate truth that half of their investments fail, on average, within the first several years of the investment.
There are a number of questions a distressed sale brings to mind. Does the board declare dividends upon the preferred stock invested in order to increase the amount paid out to the preferred – at the expense of the common – shareholders, which usually includes the founder(s)? Is there a liquidation preference in place where the preferred investors can take a multiple of their investment, (twice or three times the amount) from a sale before the common shares receive anything? Is there a participation clause in the investment agreement where, even after the preferred shareholders take their share, their stock also converts into common stock and participates (again) alongside the common shareholders?
I have been on a number of boards where just these decisions are faced, often with the corporate attorney in the room as protection, with the specter of conflict of interest looming over the discussion, as board members who are preferred investors decide how to divide the proceeds of a marginal sale of the company or its assets.
[Email readers, continue here...] A recent decision by the Delaware Court in favor of the common shareholders in marginal sales sheds light upon this dilemma for boards – at least for boards of Delaware corporations, no matter where they reside.
The Trados Decision (Delaware Court of Chancery) protects the common and early stage investors even if the late stage investors can claim all from a sale with their liquidation preferences. Directors can be held liable under certain circumstances for favoring the interests of preferred shareholders over common stockholders. This raises the bar for venture capitalists in a marginal sale of a business. It brings forward the question of conflicts of interest between VC investor board members and the shareholders they are legally bound to protect.
And yet, VCs sometimes bravely put in more money near the end of the life of a company to bridge the company to a sale of assets in an attempt to recover some or all of the original investment. This late money is at much higher risk to the VCs than even the early stage investments that were optimistically made by angels or friends and family. Most of the time, this late money is advanced in the form of a loan, and all loans are paid out of funds before any investors receive their first dollar of return. When this is the situation and the proceeds of a sale are too small to cover even the loan, there is no conflict between shareholders and note holders or VCs.
As the amounts recovered from the marginal sale increase, the conflict of interest problem becomes more acute.
Guided by the Trados Decision, preferred investors should think twice before exercising the full amount of their documented preferences in a marginal sale, volunteering to leave some of the proceeds for common shareholders, perhaps in a negotiated agreement once the amounts are known and absolute. This is rare today, but with the court decision in place, may become more of an issue in the future.
Of course, once the amounts from a sale or IPO exceed all the preferences by a substantial amount, everyone is happier since the preferred shareholders must either take their multiple of investment or convert to common, losing their preferred preferences, and participate ratably (or equally) with all the common shareholders. These are events to celebrate, since it certainly was the intent of all parties at the point of original investment to witness the day when just such a split of the proceeds would occur.