Flawed, but Fair: Updated Guidance for Boards and Investors
A recent Delaware decision, in re Trados Incorporated Shareholder Litigation , underscores a director’s responsibilities in “underwater” venture deals. In a 114-page opinion by Vice Chancellor Laster, the court reviewed the sale of Trados Incorporated, whose common stockholders received nothing in the sale of the company after the proceeds were absorbed by preferred stock liquidation preferences and a management incentive plan. Applying an entire fairness analysis, the court held in favor of the defendant directors, finding that, while the sale process was deficient in several ways, the common stock had no economic value and thus no expectation to any proceeds. However, the court was critical of the process employed by the directors and management and, if the common stock of the company had not been valueless, the decision could easily have gone the other way. Friends and clients facing the challenge of maximizing the value of a venture-backed company in which the liquidation preferences of preferred stock outstrip the value of the common should pay particular attention to this case.
The facts of this case should sound familiar to anyone who has been involved in the sale of venture-backed company.
Trados successfully developed and produced language translation software for desktop computing systems. After multiple rounds of investment, Trados’s venture capital (VC) investors held a majority of the company’s voting stock, in the form of convertible preferred shares, and were entitled to designate four of the seven directors on the board.
Trados performed well, but not at a rate that the VCs thought would generate any meaningful level of return on their investments, and the VC-nominated directors began to explore a near-term exit. The board replaced the CEO with one who had M&A process experience, engaged a financial advisor, and established a management incentive plan (MIP), directing a portion of the proceeds of a sale to management.
After initially rejecting an inferior proposal, Trados agreed to be acquired by a strategic buyer. Of the $60 million of aggregate sale proceeds, $7.8 million was distributed to management under the MIP, with the remaining $52.2 million distributed to the VC investors, whose liquidation preference was at that time $57.9 million. Nothing remained of the sale proceeds for the common stockholders. The plaintiff, who owned approximately 5% of the company’s common shares, sued, alleging that the directors had breached their fiduciary duty in approving the sale.
The Court’s Opinion
Directors were Conflicted
In evaluating the board’s actions, the court, having found that six of Trados’s seven directors were neither disinterested nor independent, applied Delaware’s “entire fairness” standard of review, which considers separately both the sale process and sale price and is a steep burden for defendants to overcome.
The court found that three of the directors who were fiduciaries of the VC funds had inherent conflicts of interest. The CEO and CFO, who also were on the board, were conflicted because they stood to receive material compensation under the MIP and were to be employed by the buyer after the sale.
The remaining conflicted director lacked independence because he had past and present business relationships with one of the VC funds. According to the court, it is rare for independent directors on the boards of VC-backed entities to ever be truly independent, due to their “web of interrelationships.”
Process Ignored the Common Stockholders
In addition to the board conflicts, the sale process was flawed in two ways: (1) the board failed to properly consider the interests of the common stockholders; and (2) the MIP improperly allocated deal consideration to management at the expense of the common stockholders.
According to the court, the directors “did not understand that their job was to maximize the value of the corporation for the benefit of the common stockholders and they refused to recognize the conflicts they faced.” The record lacked discussions of alternatives to the transaction, and showed instead that the directors were interested only in pursuing the sale process and not in continuing to manage the company as a going concern.
The court also criticized the MIP. Its effect was to remove the value to management of its own common stock while simultaneously disincentivizing management to consider common stockholder interests more generally. After the MIP was funded, the preferred stockholders received 90% of their liquidation preference in the sale and the common stockholders received nothing. In the court's view, the board did not sufficiently explore different ways to allocate the deal proceeds in the context of the deal in front of them.
Valuation Trumps in this Case
In spite of the procedural flaws, the court agreed with the defendants that the common stock of Trados had no economic value at the time of the sale. While the company was performing well, the court saw no likelihood that Trados would be able to grow at a rate that would generate a return “sufficient to escape the gravitational pull of the large liquidation preference” and an 8% cumulative dividend. The Trados directors were, accordingly, absolved of any breach of their fiduciary duties. Nevertheless, it is easy to envision a different value conclusion by the court and a consequent finding against the directors.
Key Lessons and Observations
The Trados decision highlights some of the pitfalls confronting VCs and their affiliated directors when evaluating paths to exit mixed-success investments. In such cases, the risks created by conflicting interests can best be mitigated, even if not altogether eliminated, when boards recognize those conflicts and take (and document) steps to ensure that the interests of the common stockholders are acknowledged and given due consideration in the process.
 C.A. No. 1512-VCL (Del. Ch. Aug. 16, 2013) (slip op.)
 Slip op. at 66
 Slip op. at 81
 We note that, regarding sale rights, the National Venture Capital Association, in response to Trados, has modified its Model Voting Rights Agreement to provide for certain holders of preferred stock to have the ability to cause the company to initiate a sales process. Further, in the event that a potential sale is identified, but not approved by the board, the preferred stockholders would have a right to put their shares to the company at the price that would have been obtained in the proposed sale.