Today’s middle market private equity landscape is as diverse and varied as it has ever been. With new portfolio investments scattered across a multitude of varying industries, it is clear that investor confidence has improved dramatically since the onset of the Great Recession. Yet, despite the general renewed confidence among private equity investors, one thing has and will continue to remain the same – not all equity investments are wildly successful (at least for some classes of shareholders).
Those who have been involved in the private equity space for any period of time are likely familiar with “down-round” equity financings and their impact on subsequent exit transactions. A down-round equity financing transaction is one where the target company has a “pre-money” valuation that is lower than the “post-money” valuation following its most recently completed round of financing. In other words, the target company has a lower valuation now than it did at the time of the most recently completed financing, such that the securities purchased in the current round are effectively “cheaper” based upon the lower valuation. Such down-round equity financings often serve to substantially dilute the equity positions of prior investors, as well as grant substantial management and economic rights to the investors who participate. Among other things, the end result is often that the down-round investors receive significant board representation in addition to substantial liquidation preferences (often 2.0-3.0x or more) on their invested capital, which reduces the expected returns of non-participating shareholders. As a result, down-round financings can result in preferred investors taking management control of a company that enables them to drive an exit transaction where the company is sold at or below the liquidation value of the preferred equity issued in the down-round. Consequently, preferred investors experience a positive return, while the holders of junior equity securities receive very little or no proceeds from a sale, barring a substantial turnaround of the company and the opportunity to sell for an optimistic (and often unrealistic) premium.
At first glance, the scenarios described above would likely seem grossly unfair to the common shareholders (who often include, at least in part, the individuals who initially founded the company); however, down-round financings often provide a critical capital injection into a company, without which it would not survive, and these “last dollars in / first dollars out” (or “LIFO”) arrangements are typical constructs in most investment transactions. The necessity for such financings may be the result of poor management by the founders, general economic deterioration or otherwise. In any event, the investors in a down-round financing are taking on substantial risk by committing capital to a distressed entity, and therefore expect a high rate of return, hence the aforementioned liquidation preferences that are commonplace.
Preferred investors and their board representatives should be well versed with respect to the fiduciary duties that directors owe to the company and its shareholders, or risk finding themselves in a situation similar to directors in the recent Delaware case of Carsanaro v. Bloodhound Technologies, which serves as a bleak reminder of what not to do in cases of down-round financings and exit transactions. While different states impose varying duties on directors, the majority of an investment fund’s portfolio companies are often governed by Delaware law, which is the focus of this article. Under Delaware law, a director is bound by the following duties of loyalty, care and disclosure:
The duty of loyalty requires that directors act in good faith and in the honest belief that a particular transaction is in the best interests of the company and its shareholders. Among other things, this duty requires a subordination of personal interests to the interests of the company and its shareholders.
The duty of care requires that directors exercise care in the performance of their responsibilities, meaning that such directors make a reasonable effort to consider and evaluate all material information when making decisions in their capacity as directors.
The duty of disclosure requires directors, when seeking shareholder action, to disclose to shareholders all material facts that are relevant to the action for which the directors are seeking shareholder approval.
In the event a director fails to comply with these fiduciary duties when taking a particular action, the action taken can be subject to invalidation and the director may face personal liability for the consequences of the action taken. Of particular importance to private investment funds making preferred investments in portfolio companies, the Delaware Court of Chancery has held that directors owe these fiduciary duties to both preferred and common shareholders, but where a right claimed by preferred shareholders is a preference against the common stock, it will generally be a director’s duty to prefer the interests of common stock to the interests of the preferred stock, where a conflict exists. Certainly, this may come as a surprise to some. If a down-round equity financing is completed, and the company is ultimately successful thereafter, any shareholders that did not participate in the down-round may very well allege that the approval of the down-round transaction was tainted by the involvement of “interested directors” who breached their fiduciary duties to the company’s existing shareholders by authorizing the transaction.
Generally, director decisions are shielded by the “business judgment rule,” which is a presumption that directors acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interest of the company. However, the business judgment rule is not applicable in interested director transactions. In the case of such interested director transactions, the interested directors bear the burden of establishing the “entire fairness” of the transaction. Typically, an interested director transaction is one in which (i) certain directors have a material financial interest in the transaction that is not shared by the company and its shareholders and (ii) the materially self-interested directors: (a) constitute a majority of the board, (b) control and dominate the board as a whole, or (c) fail to disclose their interests in the transaction where a reasonable board member would have regarded the existence of their material interests as a significant fact in the evaluation of the proposed transaction.
To prove the entire fairness of a transaction, one must show the existence of fair dealing as well as fair price. With respect to the fair dealing component, this involves an analysis of procedural matters such as how the transaction was timed, structured and negotiated, and how the approvals of the requisite directors and shareholders were obtained (including whether adequate disclosures were made in connection with it). With respect to the fair price component, a court will determine fair price as an amount that is within a range that a reasonable person with access to relevant information might accept.
So what are preferred investors and their board designees to do? While there is never a guarantee that a given action will be fully-insulated from a shareholder challenge with respect to the entire fairness standard, the list below sets forth some recommended steps that should be considered in connection with evaluating and approving, as applicable, any down-round financing or sale of the company at or below the preferred liquidation preference:
Ensure that there are no more attractive alternatives available. This should involve a thorough canvassing of the market to determine what alternatives are available, with the board’s findings to be thoroughly documented and included in the minutes of the board meetings.
Have multiple board meetings to evaluate available alternatives and make decisions, including specific discussions regarding the impact on junior equity classes. By holding multiple, well-documented meetings the board will be better positioned to argue that a thorough evaluation and decision-making process was undertaken. Additionally, the earlier the evaluation process can begin, the better, as the company is more likely to have a greater number of alternatives (with better terms) to choose from if a proper amount of time is allotted to the process.
Offer minority shareholders the right to participate in the down-round on a pro rata basis. By offering all shareholders the right to participate, the investor(s) leading the down-round will be viewed more favorably (and less like the bully on the block that is intentionally washing out the minority positions of others). Moreover, it becomes more difficult for a minority shareholder to argue that a fair price was not obtained when such shareholder, in fact, rejected that price.
Appoint a special committee of disinterested directors to evaluate the transaction. A court will be less likely to find that a director acted improperly in approving a particular action if such approval was based on an unbiased recommendation from a bona fide special committee that was appointed to independently evaluate the transaction.
Obtain a fairness opinion or an independent appraisal from an investment bank or independent advisor to support the valuation of the company upon which the transaction is based.
Provide for a nominal “carve-out” for common shareholders in connection with sale transactions at or below the preferred liquidation value, such that the common shareholders receive at least some proceeds from the sale.
Include a well-crafted drag-along provision in shareholder agreements. While not necessarily determinative, the presence of a drag-along provision can arguably serve as a good fact for the investor(s) leading a sale transaction. To the extent a sale transaction is being effectuated by using such a drag-along provision, ensure that the parties entitled to exercise the drag-along right comply strictly with its requirements.
Use discretion when taking actions that, while contractually permitted, may be viewed with disfavor by a court. For example, a preferred investor may have a broad contractual right to amend the portfolio company’s operating/governance documents, including the ability to eliminate notice requirements or similar rights otherwise provided to holders of junior classes of equity. Unless absolutely necessary to consummate a particular transaction, such actions should be avoided as they may trigger an increased level of judicial scrutiny.
Attempt to secure a disinterested third party to lead any down-round financing. It will be much more difficult to argue that a director was breaching his or her duty of loyalty to the company and its shareholders if the transaction is negotiated at arms’ length with an unaffiliated third party.
Solicit the approval of the disinterested shareholders and distribute robust information statements to all shareholders with respect to the contemplated transaction, including unambiguous explanations of the anticipated effect on all classes of equity interests.
Document, document, document! It is absolutely critical to maintain detailed records setting forth the alternatives considered (including all efforts made to locate prospective investors/purchasers, whether undertaken by financial advisors or otherwise), the actions taken and the underlying rationale for them.
In summary, down-round financings (as well as subsequent exit transactions that result in most or all of the sale proceeds being allocated to preferred investors) are not uncommon, and carry with them the risk that a class of junior equityholders may bring a challenge. Practically speaking, it would be rare for all of the above recommended actions to be taken in connection with a particular transaction, given the associated time and expense (and in some cases, futility). For any number of reasons, certain of these actions may or may not be feasible or desirable in a given scenario. Nevertheless, preferred investors and their board designees should endeavor to employ as many of these strategies as are practicable in a given situation, or risk greater exposure to shareholder litigation and increased judicial scrutiny.
 Carsanaro v. Bloodhound Technologies Inc., Del. Ch., C.A. No. 7301-VCL, 3/15/13.