Some sales of private companies are terrific events. Big valuations can lead to all investors getting paid, not to mention dancing and high-fives all around.
But what happens when the sale is a sad one? Sometimes, the answer is that the venture capital investors get paid first—often at a multiplier of what they invested—and leave the common stock holders with little or nothing.
This is what happened in the Trados Inc. case – an eight-year dispute over actions taken by its board involving preferred stocks, common shareholders and the sale of a company that never became profitable.
While the Delaware Chancery Court decision finally closed the case in 2013, the lessons learned are timeless. When informed parties talk about director fiduciary duties vis-à-vis the sale of a private, venture capital-backed company, they cite Trados.
First, a reminder about the situation that sent Trados in court in the first place. Like so many private companies, the venture investors who backed Trados had negotiated for preferences upon the liquidation of the company. The rights associated with the preferred stock purchased by the Trados investors were normal, market standard sort of rights.
Of course if Trados had gone public (and in some other circumstances), the preferred shares would have converted into common stock. As a result, all shareholders would have participated equally in the upside. For whatever reason, this was not to be Trados’ destiny.
The Trados board of directors decided to sell the company. It should be noted that this decision was made at a time when Trados’ results were improving. Did the board jump the gun (to the detriment of the common shareholders), or did they spruce up the house before posting the “For Sale” sign? We don’t know.
The decision to sell was made, bankers were then hired, and the board of directors oversaw the transaction. The board, however, included individuals who were appointed by and were representing investors with liquidation preferences (i.e., the venture funds that had invested in exchange for preferred stock).
Did the board sell the company prematurely? If the board had waited, would the company have been worth a lot more? Did the board in fact have a duty to the common shareholders to wait to sell the company until it could command a greater sale price? The common stock plaintiff who sued thought so – especially since the preferred stockholders – the VCs – obtained proceeds from the sale, whereas the common shareholders received nothing.
In the end, the Delaware Chancery Court found that, in fact, there was not a fair process in place for the sale of Trados, yet the price was fair because the shares held no economic value. It’s a bit of a “no harm, no foul” kind of outcome—except that it took about eight years of everyone’s life, not to mention lawyers’ fees, to get there.
So what does Trados teach us about preparing for risk, understanding the basics of fiduciary duty for private companies, and obligation to shareholders?
First, Trados teaches us that directors are accountable first and foremost to common shareholders (and not to preferred shareholders) when it comes to exercising fiduciary duty.
Secondly, basic risk management can go a long way. If you’re a private company director, consider the following:
- Consider forming a special committee—comprised solely of independent directors—to oversee the sale of a company. When selling a company, consider conflicts from a “what is the worst possible interpretation of what we are doing” perspective. This might mean appointing new directors who do not represent venture funds (and are not too friendly to the represented venture funds either, for that matter). The Trados court afforded the Trados board no deference because a majority of the board had conflicts of interest. As a result, the board could not win a motion to dismiss and instead endured a trial under the difficult “entire fairness” standard of review.
- When a company is for sale, exercising Revlon duties appropriately is crucial for minimizing the litigation risk a company faces after a sale—or at least for obtaining a more deferential standard of review. This includes making sure that independent directors with no conflicts have a process for ensuring the best possible price for common stockholders. I wrote about how to create a process for minimizing risk in a previous post written here.
- Having the right insurance coverage is useful for handling post-acquisition claims that could arise long after the sale. The term of art is a “D&O tail policy,” and you can learn more about how that protects companies in a post I wrote here.
After a sale of a company, the win isn’t successfully defending yourself in litigation; it’s avoiding the litigation in the first place. No one wants to slow walk the sale of a dying company, but Trados teaches us to do it right the first time, or potentially suffer many years of expensive, time-consuming litigation proving that what you did was fine.
The views expressed in this blog are solely those of the author. This blog should not be taken as insurance or legal advice for your particular situation. Questions? Comments? Concerns? Email: firstname.lastname@example.org.