Start-ups are broadly distinctive from larger enterprises in that the persons who hold a large if not majority stake in the company - the founders – often comprise the board of directors. This can introduce ambiguity as to whether director actions are subject to the “business judgment rule” (where a director’s obligation is simply to act in good faith) or rather a generalized fairness doctrine (where an approved transaction, viewed objectively, must have been fair and reasonable).
When startups encounter liquidity concerns that require corporate decisions with respect to debt incurrence, recapitalizations, or liquidation events there is a heighted opportunity for minority shareholders (and in some cases creditors) to file lawsuits targeting founders personally.
Generally, within the startup context, a down round or cramdown financing or liquidation sale presents the highest risk for this kind of litigation. On the financing side the underlying issue is often dilution of a minority shareholder. For example, if minority shareholders lack pro rata rights (which depends on the financing documents) then majority stakeholders (this may include founders) are incentivized to underprice the round and come out with portion of the equity incommensurate with the size of capital investment. In a cramdown or recapitalization scenario minority shareholders or convertible debt holders (such as SAFE holders) (pursuant to the financing documents and company charter) are perforce converted into common stock (or other less preferential class of stock). In a sale event, liquidation preferences, inside information or special incentives afforded founder employees (such as incentive equity grants in the acquirer) may result in the aggregate sale consideration being inequitably allocated among the shareholders.
In all of the above scenarios a minority shareholder is positioned to claim damages based on a founder director violation of fiduciary duty. Interestingly, in a down round or cramdown financing a nonparticipating investor may have an economic incentive to sit on any alleged grievance until the company has reversed its fortunes and is positioned for a successful exit.
How can founder directors reduce the risk of litigation? Good governance hygiene varies with the circumstances but overall the following measures go a long way to reducing the likelihood of a lawsuit:
-Seeking 100% stockholder approval even if such approval is not technically required under previous financing agreements helps rebut any ex post facto claim that a transaction was unfair.
-Full disclosure of terms to stockholders, with particular detail on the benefits of the financing terms to the controlling investors (e.g., the board members) and factors that would adversely affect or impact non-participating shareholders. Disclosure should be inclusive of benefits that go beyond the share value (such as on-going employment).
-Specifically in the context of financings, allow for equal participation in, or a rights offering that accompanies, the financing, even if not required by the previous financing documents. Shareholders should be permitted the right to participate in the financing on or participate on substantially the same terms as the inside investors.
-The board should consider alternative viable funding and/or liquidation options and document that diligence through company records, meeting minutes and board consents.
In addition, there are time-tested, well-worn methods established by Delaware case law for fiduciaries stewarding brink-of-insolvency companies – fairness opinions from financial advisors, meticulous documentation, disinterested board committees, and gold standard legal counsel. These methods are recommended and best practice and make sense along with 8 hours of sleep and daily meditation and cross-fit. They’re available to the extent they’re available.
Taken as a whole the prophylactic measures bullet-listed above provide a solid front line defense to unfairness claims and do not require significant investment beyond concerted attention and company counsel recording and otherwise taking account of those measures in board minutes, board and shareholder resolutions, and any relevant transaction paperwork.
This alert was prepared by Jake Molland, a Principal at Bound Legal Strategy P.C. The content of this alert is informational only and does not constitute legal or professional advice. Please note that the law changes frequently and further that the generalized information reflected in this alert may not address the specifics of a given factual situation. Please contact Jake at jake.molland@boundlegal.com if you have specific questions or concerns relating to any of the topics covered in here.
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