This piece was initially posted on Tumblr on May 15, 2013; it is reposted here. ©David Jargiello 2013-2016 All Rights Reserved.
Simply stated, Carsanaro v. Bloodhound Technologies, C.A. 7301-VCL (Mar. 15, 2013) is a 76 page tour-de-force of Delaware corporate law regarding the liability of venture capitalists for highly dilutive (aka “washout”) financings. Although Carsanaro has been reviewed by better bloggers than this one (see e.g., Pileggi blog, PotterAnderson blog, or Kennerly blog), several “between the lines” practical points caught my eye.
A – Backstory Highlights
Carsanaro formed Bloodhound Technologies (“Bloodhound” or the “Company”) in 1998. As the Company’s CEO, Carsanaro negotiated and closed a Series A Preferred Stock round in 1999 with VC#1, and, a Series B Preferred Stock round in early 2000 with VC#2. With venture capitalists in control of the Bloodhound board, Carsanaro was ousted from all positions with the Company in December 2000. A Series C Preferred Stock round with VC#3 was closed in early 2001, and a Series D Preferred Stock round with board insiders (i.e., VC#1, VC#2 and VC#3) was closed later that same year. For purposes of this post, Bloodhound’s pre-money valuation increased with each successive round from Series A to Series D.
Between 2002 and 2006, the board insiders (VC#1, VC#2 and VC#3) continued to finance the Company via a series of highly dilutive “down rounds.” The dilutive security in each instance was a cheaper Series E Preferred Stock that also sported a 3x liquidation preference. Notably, despite alleged steady improvements in Bloodhound’s business, the price of the Series E Preferred Stock never changed during the four year period in question. In 2011, Bloodhound was sold for $82.5 million. Based on facts stated in the underlying complaint, the proceeds of that sale were allocated as follows:
** As a result of liquidation preferences on the Preferred Stock, VC#1 received approximately $2.1M, VC#2 received approximately $13.9M and VC#3 received approximately $27M. Carsanaro, at 14.
** As a result of a “management incentive plan” approved at the time of the merger, $15M was allocated to management. Carsanaro, at 14.
** Finally, since all of the Preferred Stock was apparently “participating,” the remaining amount (approximately $4.5M) was allocated pro rata among all stockholders on an as converted basis. Carsanaro, at 14.
Upon receipt of just over $29,000 based on his (by then massively diluted) holdings, Carsanaro brought this action against VC#1, VC#2 and VC#3 challenging the “insider” rounds and the allocation of merger proceeds on a variety of legal theories. Defendant VC’s moved to dismiss. By this ruling, the Court of Chancery largely held for Carsanaro, meaning that he had stated colorable – though not necessarily valid – claims under applicable Delaware law.
B – Observations
1 – Scrivener’s Error.
In connection with the very first of the Series E down rounds, Bloodhound effected a 10-for-1 reverse stock split (the “Reverse Split”). Mechanically, counsel undertook this process in two steps: (1) a Certificate of Amendment to Bloodhound’s Certificate of Incorporation was filed effecting the reverse split, and then immediately thereafter (2) an Amended and Restated Certificate of Incorporation (the “Series E Charter”) was filed to authorize the new Series E Preferred Stock.
As the Court of Chancery reports …
“Bloodhound filed the certificate of amendment effecting the Reverse Split, then filed the Series E Charter shortly thereafter. But the Series E Charter did not adjust the conversion prices of the Series A, B, or C Preferred to account for the Reverse Split. By keeping the conversion prices constant, the Series E Charter made those shares’ conversion rights ten times more valuable.” Carsanaro, at 9 (original emphasis).
Hmmm … An intentional business move or a scrivener’s error? The Board’s behavior suggests the latter …
“Because the failure to adjust the conversion prices would dilute not only the [C]ommon [S]tock but also the Series D and E Preferred, Bloodhound entered into separate agreements with the holders of Series D and E Preferred to issue them additional shares. The dilution from the failure to adjust the conversion prices fell squarely on the Common Stock.” Carsanaro, at 9 – 10 (emphasis added).
Although it is impossible to know for sure from the published opinion, it appears from this characterization of events that (1) Bloodhound filed a Series E Charter with a typographical error, and then (2) “fixed it” by “grossing up” certain insider stockholders with extra shares to compensate them for the unintended economic consequences (as opposed to the correcting it by appropriate statutory instrument (e.g., a Certificate of Correction)).
My Comment … “Grossing-up” a scrivener’s error for the benefit of some – but not all – of the affected stockholders is, well, ill-advised. Viewed in the most charitable possible light such an action creates an appearance of impropriety that will allow a claim to survive a motion to dismiss, as was the case here.
2 – Board Consent Problem.
On a related note, the Court of Chancery observed that …
“The failure to adjust the conversion prices [in the Series E Charter] was contrary to the board resolutions that authorized the Series E Financing. That resolution stated:
’[I]n connection with the [Reverse Split] … the respective conversion prices of the issued and outstanding shares of Series A Preferred Stock, Series B Preferred Stock, Series C Preferred Stock and Series D Preferred Stock of the Company … shall be proportionately adjusted in accordance with the terms of the Amended and Restated Certificate of Incorporation.‘ “
Carsanaro, at 10 (emphasis added).
Thus, because “[t]he actual certificate filed by Bloodhound with the Secretary of State did not revise the conversion prices of the Series A, B, or C Preferred,” the Series E Charter was in violation of Section 242(b)(1) [of the Delaware General Corporation Law] in that it failed to “conform to the resolution adopted by the board.” Carsanaro, at 27 (original emphasis).
As a ruling on a motion to dismiss, Carsanaro includes no discussion of the consequences of this violation other than to conclude that plaintiffs stated a valid claim. That leaves it to bloggers to ponder the practical meaning of such a Section 242(b)(1) violation … . Was the Series E Charter “voidable” (as opposed to “void”) and if so, to what end? See, e.g., Bigler and Tillman, Void or Voidable (2008). For example, any third party legal opinions delivered by company counsel would presumably be in error, and counsel would more generally be exposed for the consequential damages flowing from the issuance of a voidable series of preferred stock.
My Comment … Yet another reason that an erroneous Certificate of Incorporation should be corrected through an appropriate statutory instrument, and not otherwise “fixed” through what might appear to be “easier” inter-stockholder business dealings.
3 – Stockholder Consent Problem.
Carsanaro gives a moment of pause regarding the common practice of “circulating sig pages” in the usual hubbub surrounding a venture capital closing … “[L]ess than four hours before filing the amendment giving effect to the Reverse Split,” the Company emailed an “Action by Written Consent” to a holder of Common Stock whose vote was essential. The form consent referenced certain documentation for the Reverse Split supposedly – but not in fact – attached as exhibits. Carsanaro, at 12.
In response, the stockholder sent an email to the Company … .
“I‘ve reviewed the [stockholder consent form] and while I have no problem signing the document in principle, I would very much appreciate getting [the exhibits] so I can understand the full scope of what I am signing … . I am ready to sign this document as soon as I‘ve had a chance to review the above mentioned exhibits and resolutions.” Carsanaro, at 12.
Feeling pressured, the stockholder nevertheless signed the consent and the Reverse Split became effective; one month later, he received the exhibits in question. Carsanaro, at 12.
Per the Court of Chancery …
“Because Section 228 [of the Delaware General Corporation Law] permits immediate action without prior notice to minority stockholders, the statute involves great potential for mischief and its requirements must be strictly complied with if any semblance of corporate order is to be maintained … When a consent specifically refers to exhibits and incorporates their terms, the plain language of Section 228(a) requires that a stockholder have the exhibits to execute a valid consent. [As a result,] [t]his aspect of [the subject count] states a claim.” Carsanaro, at 28.
My Comment … Carsanaro sends a shot across the proverbial bow with respect to this not uncommon venture capital practice … “Sig pages attached – Sign ASAP so we can close – Attachments later.”
4 – Redemption Rights Can Be Illusory.
The VC defendants sought dismissal of Carsanaro’s claims …
“… on the theory that the preferred stockholders could have acted together to take 100% of the value of the Company by exercising their redemption rights. According to the [VC] defendants, the preferred investors had a … right under the certificate of incorporation to force the Company to redeem their preferred shares at any time. … The [VC] defendants say they cannot be held liable in connection with [a sale of the Company] in which the common stockholders received at least something, because they had a … right to take everything.” Carsanaro, at 33.
Hmmm … That makes sense, right? We have redemption rights worth more than the company is worth, so it’s our company, right?
As the Court of Chancery correctly notes ”[a] redemption right does not give the holder the absolute, unfettered ability to force the corporation to redeem shares under any circumstances,“ but rather the right to be repurchased under the specific circumstances stated in Section 160 of the DGCL. Carsanaro, at 33.
In short, Section 160 says that a corporation can only redeem (1) out of “surplus” (the value of a corporation’s net assets less the par value of outstanding capital stock), and (2) when there are “legally available funds” (a facts-and-circumstances driven determination balancing (a) whether the redemption would result in insolvency, (b) whether the redemption would jeopardize the corporation’s ability to continue as a going concern, © whether the redemption would jeopardize the long term financial health of the corporation, (d) whether the redemption would jeopardize the corporation’s ability to pay its debts when due, and (e) whether the redemption would lessen the security of the corporation’s creditors).
My Comment … It is a common misconception – one that is heard time and again – that a redemption right gives the VC’s the right to “take” the company. A redemption right gives the VC’s a right to have their shares repurchased under certain limited circumstances that rarely occur in the real start up company world. Further, the real practical “value” of redemption rights is that as a matter of law they distinguish preferred stock from debt. See, e.g., Harbinger Capital Partners Master Fund I, Ltd. v. Granite Broad. Corp., 906 A.2d 218, 225-26 (Del. Ch. 2006) (restrictions on redemption imposed by Section 160 are one critical factor that distinguishes preferred stock from debt).
5 – “Dual Fiduciary” Problem.
Carsanaro is good read and reminder on several points regarding venture capital board seats.
For clarity here, I’ll define a “Venture Capital Board Representative” as (1) a member of the Board of Directors of “StartUp,” that is also (2) a venture capitalist, in (3) a venture capital fund that owns some sort of traditional NVCA-esque Preferred Stock in StartUp. Using that definition, a Venture Capital Board Representative is a classic “dual fiduciary,” with parallel obligations running to (1) the stockholders of StartUp, and (2) the limited partner investors in his or her venture capital fund.
Reminders from Carsanaro …
** First, at a personal level, a Venture Capital Board Representative does not get a “break” or some sort of lesser obligation(s) by virtue of being a dual fiduciary … “[t]here is no dilution of [fiduciary] obligation where one holds dual or multiple directorships or otherwise confronts the conflicting pull of competing fiduciary roles.” Carsanaro, at 22 (citing Weinberger v. UOP, Inc. 457 A.2d 701 (Del. 1983)).
** Second, at a transactional level, with respect to a corporate matter that benefits the holders of StartUp’s Preferred Stock, a Venture Capital Board Representative is “interested” for pleading purposes if his or her venture capital fund is a holder of any of StartUp’s Preferred Stock. Carsanaro, at 22 (citing In Re Trados Incorporated Shareholder Litigation No. 1512-CC (July 24 2009)).
** Third, at a Board of Directors level, “[a] board that is evenly divided between “interested” and independent members is not considered independent and disinterested.” Carsanaro, at 20.
** Finally, at a “rules” level, a Board of Directors that is “not … independent and disinterested” as to a particular matter does not enjoy the protection of the Business Judgment Rule, but rather bears the burden of proving – if challenged – that such matter was “entirely fair.” Carsanaro, at 20-23.
My Comment … Simply stated, good stuff that is often forgotten, overlooked and/or misunderstood.
6 – Director Behavior.
Finally, Carsanaro is also a good read and reminder on the topic of the “Business Judgment Rule” and the practical functioning of “interested” boards in venture backed companies. A quick recap on the Business Judgment Rule …
(a) Under Delaware law, the business judgment rule is a presumption that in making a business decision the Board of Directors 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.
(b) A party challenging a decision made by the Board of Directors has the burden of rebutting that presumption.
(c) If a party challenging a decision made by the Board of Directors cannot rebut that presumption, then no court will “second-guess” the Board’s decision.
(d) If a party challenging a decision made by the Board of Directors can rebut the presumption, then the burden shifts to the Board to prove the “entire fairness” of the transaction or act in question vis-à-vis the company’s stockholders.
With that in mind, following are some tidbits from Carsanaro …
Regarding the “Inside” and “Upside” Series D Round:
“The business judgment rule is rebutted with respect to the Series D Financing because only two of the six members of the [Board of Directors] … were disinterested and independent. The complaint‘s allegations about the unilateral setting of the terms of the Series D Financing, without any market canvass [for outside investors] … give rise to a reasonable inference of unfairness.” Carsanaro, at 23.
Regarding the “Inside” and “Downside” Series E Rounds:
“The business judgment rule is rebutted with respect to the Series E Financing because “only one member of the [Board of Directors] was disinterested and independent. The complaint‘s allegation that the [Board of Directors] accepted the [insiders’] opening proposal, without negotiation or any effort to explore alternative financing, supports a reasonable inference of unfairness … [as does] the failure to adjust the conversion prices of the Series A, B, and C Preferred and the self-interested step of mitigating the dilution for holders of Series D and E Preferred, but not for the holders of the common.” Carsanaro, at 24.
Regarding the Management Incentive Plan:
“The diversion of 18.87% of the Merger consideration through [a management incentive plan benefiting a majority of the Board of Directors] support[ed] a reasonable inference that the Merger was unfair.” Carsanaro, at 29.
My Comment … Process, Process, Process, Process. Process. There is absolutely nothing “wrong” per se with an “interested” Board of Directors. In fact, it is more common than not in venture capital circles. Rather, when the Board is “interested” what is important is director behavior. My personal “Big Four” … (1) attend meetings, read board material, understand the business and its financials; (2) actively deliberate matters that come before the board (i.e., consider alternatives, discuss strategies and differences of opinion); (3) appropriately document the deliberative process in the minutes; and (4) know the limits of the attorney client privilege as it relates to board discussions with counsel, as well as the scope of electronic discovery.
C – Wrap
As noted above, just some practical pointers I extracted from the published opinion text. As a Delaware law matter there is much more to Carsanaro than reported here … see the Pileggi blog, PotterAnderson blog, or Kennerly blog, or the published opinion for details.
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