Common versus preferred

More on the continuing legal education day I had at the Wilson Sonsini office yesterday:

One panel in the afternoon talked about the recent Trados decision, a case tried in Delaware under Delaware law, even though the company was venture backed and based in California.

494297160_1c17373199_oThat's typical, of course. The vast preponderance of Silicon Valley, venture-backed startups and emerging companies are Delaware corporations. Lawyers and entrepreneurs opt for Delaware, in large part because California is not a viable incorporation alternative. (That's not true in Washington. In fact, this case makes me wonder if it isn't a good tiebreaker when considering Washington and Delaware.)

As with the panel that talked about social media and material disclosures under Reg FD in the morning, this afternoon panel about Trados included a lawyer who had participated in the case. Again on the company side.

I won't actually discuss the case itself, because I feel I should read the court's opinion first, before doing that. Suffice it to say that the case stands for the fear (if your inclination is to equate the health of the startup and emerging company tech sector with the health of the venture capital industry) that Delaware corporations with interlocked or conflicted boards may have to clear an "entire fairness" test, if sued by founders or common shareholders alleging that a sale of the company was designed to clear VC liquidation preferences and management incentive plans, leaving no sale proceeds for the common.

In the Trados case, it just so happened that the company ended up establishing that the price paid in the M&A transaction was actually fair. But, not having the benefit of the business judgment rule or other lower standards, normally applicable when a non-conflicted board oversees an exit, it took years of expensive litigation to get there. (Practice tip from the litigator involved in the case: don't just get $1 to $3 million in D&O insurance; buy the $3 to $5 million coverage.)

Thus the fear. Because Silicon Valley is a small town, because VCs follow one another and everybody is on everyone else's board, doesn't it seem like this standard of fairness from Trados - something designed for the GE's and IBM's of the world, you might say - doesn't it seem like a disaster?

One of the Wilson lawyers walked through some possible strategies or tactics by which to cope. These include:

  • A really, really tough and comprehensive drag along covenant, applied to everyone;
  • Amending the company's charter prior to sale, to change the liquidation preferences to ensure that the common gets something;
  • Designing management incentive plans differently, to ensure that the preferred and the common contribute to it proportionally.

Fascinating stuff.

Of course, from the perspective of up here in Washington, it's a bit easier to also wonder, what about just selling common stock to everyone?

I'm being facetious, but I'm not.

I generally think it's entirely fair and appropriate, and even prudent, not to mention a market reality, for startup founders to give outside investors a simple liquidation preference on angel or VC investments. But if you (later) get into a cycle of down rounds and multiple liquidation preferences, and if you stop caring so much that the common stock options are underwater because you think management incentive plans can fix the problem for the management team, you may be approaching a situation where early founders and rank and file employees just don't get that a $60 million sale may mean as good as a bankruptcy, as far as they're concerned.

Photo credit: vistavision / Flickr.

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