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.

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.

The role of the participating inside investors in an insider-led down round financing, who have the ability both to set the investment terms and make the investment, creates tension between management and minority stockholders on one hand, and the participating inside investors on the other. In addition, former founders or early investors not participating in the financing may perceive that the participating inside investors are attempting to secure control of the company by diluting their equity position.

Furthermore, the directors affiliated with the participating inside investors are often regarded as having a conflict of interest with regard to their approval of the down round financing.  This conflict of interest creates a difficult legal environment surrounding the actions of the board members and the company.

The actions of the board of directors are governed under state law by the business judgment rule.  This rule creates a presumption that business decisions made by a board of directors will be given deference by the courts if the board’s judgment is exercised diligently and in good faith.  Where the board’s decision may be influenced by conflicting financial interests of the directors (a so-called interested transaction), as in a down round financing, the favorable presumption of the business judgment rule falls away.  In these situations, the transaction is voidable by the shareholders or the company. Under corporate statutes in both Delaware and California, the board may successfully avoid an attempt to void the transaction by showing that the transaction was approved by a vote of the disinterested board members or a special committee, or by a vote of the disinterested stockholders or by proving that the transaction was intrinsically fair and reasonable at the time it was authorized by the board.

If the members of the board were to be found to have breached their duties, state law provides that they may be personally liable for their actions.  Since most private companies don’t carry directors’ and officers’ liability insurance and may not have the cash resources to engage in sustained litigation, the threat of personal liability can be serious.

Other theories of liability have been advanced based on the controlling influence that a venture fund or its general partners may have over the actions taken by a portfolio company.  These theories are based on facts which can demonstrate that a controlling stockholder has breached its fiduciary duty to minority stockholders, or that venture funds or their general partners have conspired with each other to aid and abet a breach of fiduciary duty owing to the stockholders.

There are a number of steps that a board of directors and the company can consider to reduce the risk of litigation from disenchanted stockholders when faced with a dilutive financing driven by inside investors.

• A compelling board record. Board minutes reflecting the board’s thinking and analysis are important. Board members typically should meet in person or by conference telephone as opposed to taking action by written consent, and should devote more than a single meeting to decide to proceed with a down round financing. The minutes should reflect the board’s rationale for considering a down round financing and its efforts to recruit potential third-party investors.

• Diligent assessment of alternatives. The board should attempt to demonstrate that it has considered all reasonable alternatives to the insider-led round. Although actual contacts and presentations with possible new investors are not legally required, if the company has not attempted to engage with new investors, there should be a plausible reason in the record for the board’s decision.

• Approval by independent directors. Approval of the financing terms by the independent directors, or by a special independent committee of the board empowered to authorize the financing, may allow the board to take advantage of the business judgment rule.  Independent director approval may not be practical, however, in many circumstances.

• Disinterested stockholder approval. Down round financing structures typically require stockholder approval. Securing the approval of the stockholders who are disinterested helps the company defend against an attempt to void the transaction by disenchanted stockholders.

• Full disclosure of terms. Complete disclosure of financing terms is essential in a down round, with particular consideration of the benefits of the financing terms to the inside investors, the likelihood of replenishment of equity incentives to management and employees following completion of the financing, and factors that would adversely impact non-participating stockholders.

• Rights offering. Perhaps one of most important steps in an insider-led down round financing is a rights offering that accompanies or follows the financing. All stockholders of the company, and frequently including employees with vested options and warrant holders with “in the money” rights, should be permitted the right to participate in the financing on substantially the same terms as the inside investors. The disclosure or information statement provided to all stockholders of the company can serve to summarize the financing terms while soliciting the interest of potential investors. The rights offering should be structured in a manner to comply with applicable state and federal securities laws and should allow sufficient time to allow potential investors to respond to the offer.

Unfortunately, there is no single step or combination of steps that can completely remove the risk of legal exposure in a down round financing. Board members may be faced with the difficult decision of proceeding with a financing that may result in litigation or shutting down the company.

[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).

• Full ratchet anti-dilution protection. Investors in risky financings may request full ratchet anti-dilution protection to protect against future down round financings.

• 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.