Navigating Conflicts in Rescue M&A and Financings
Imagine you are a founder or director of a Series B-stage B2B technology startup. You have gained commercial traction but have not quite hit your growth targets in core and expansion markets—perhaps due to pursuing too many initiatives too quickly. Your Series C has not crystalized yet, causing you to tighten operations. Now, you are seeking bridge financing and your board is beginning to suggest pursuing M&A exit options—especially if strategic buyers or opportunistic lower-middle market funds show interest.
Even though you are generally familiar with fiduciary duties, you may have unknowingly entered a complex zone rife with conflicts of interest and litigation risk. And you would not be alone—today’s volatile fundraising climate and limited exit pathways have led to an uptick in creative financings and sub-optimal (yet still commendable) M&A outcomes. In this environment, founders and board members must be especially attuned to the conflict of interest traps that increasingly lead to costly litigation.
(This post assumes that the startup is incorporated in Delaware. For more information regarding in which state to incorporate, please see this article.)
Fiduciary Duties
Experienced directors and officers understand that they owe the traditional fiduciary duties of care (make reasonable, informed decisions) and loyalty (act in the best interest of the corporation and its stockholders). But during times of financial stress, even sophisticated directors may overlook a crucial nuance: Their primary fiduciary duty runs to common stockholders, not preferred stockholders (or their LPs). If a company dips into the zone of insolvency—common test: Can the company pay its debts as they come due?—the fiduciary obligations can even extend to include the company’s debtholders.
Another layer of complication is that companies weighing an exit M&A transaction often require bridge financing from insiders (because if they could raise money from new investors, they would have done so). These intersecting issues create fertile ground for conflicted decision-making.
How can you better protect yourself and your fellow directors and officers from costly litigation?
Common Conflicts of Interest Scenarios
Mitigating Conflicts: Tools for Companies
While it may not be possible to entirely avoid conflicts, boards can take disciplined actions prior to and during transactions to mitigate their liability and allow transactions to stand up to judicial scrutiny.
A Safe Harbor
Delaware law recently changed to allow boards to avoid breach of fiduciary duty claims due to conflicts of interest if proper procedures are followed. Generally, in transactions posing conflicts of interest with directors/officers or a sale of the company to a non-controlling stockholder, a safe harbor applies to transactions that are approved either by (i) a majority of disinterested directors (potentially acting through a special committee with delegated negotiation authority) or (ii) the uncoerced, affirmative vote of a majority of votes cast by disinterested stockholders. Many startups are hesitant to appoint multiple independent directors to a board or spend the legal fees to have separate legal counsel for a special committee, but given the new legal framework and litigation climate in Delaware, the advantages for doing so are greater than ever.
Other Best Practices
If taking the steps necessary to qualify for the safe harbor is not practical, boards can still follow healthy practices to limit the impact of conflicts of interest, including:
By proactively identifying and mitigating conflicts, founders and directors can reduce litigation risk, protect long-term reputations, and increase the likelihood that critical M&A and financing transactions withstand both shareholder scrutiny and judicial review.
Even though you are generally familiar with fiduciary duties, you may have unknowingly entered a complex zone rife with conflicts of interest and litigation risk. And you would not be alone—today’s volatile fundraising climate and limited exit pathways have led to an uptick in creative financings and sub-optimal (yet still commendable) M&A outcomes. In this environment, founders and board members must be especially attuned to the conflict of interest traps that increasingly lead to costly litigation.
(This post assumes that the startup is incorporated in Delaware. For more information regarding in which state to incorporate, please see this article.)
Fiduciary Duties
Experienced directors and officers understand that they owe the traditional fiduciary duties of care (make reasonable, informed decisions) and loyalty (act in the best interest of the corporation and its stockholders). But during times of financial stress, even sophisticated directors may overlook a crucial nuance: Their primary fiduciary duty runs to common stockholders, not preferred stockholders (or their LPs). If a company dips into the zone of insolvency—common test: Can the company pay its debts as they come due?—the fiduciary obligations can even extend to include the company’s debtholders.
Another layer of complication is that companies weighing an exit M&A transaction often require bridge financing from insiders (because if they could raise money from new investors, they would have done so). These intersecting issues create fertile ground for conflicted decision-making.
How can you better protect yourself and your fellow directors and officers from costly litigation?
Common Conflicts of Interest Scenarios
- Directors Appointed by Large Stockholders: Often, a majority of directors are appointed by key preferred stockholders (in which the director typically has a financial interest). These directors must still prioritize common stockholders, especially when considering an M&A deal that may fully repay preferred stockholders while providing common stockholders with little or nothing.
- In re Trados Inc. Shareholder Litigation (August 2013) and In re Good Technology Stockholder Litigation (August 2018) exemplify this risk. Venture capital-appointed directors were sued when they approved deals in which the preferred stockholders received at least a majority of the sale proceeds. Delaware courts applied the “entire fairness” standard of review, and in the latter case, the parties settled for over $50 million in damages.
- Insider Bridge Financings: To extend its runway to pursue an M&A transaction, startups often accept bridge financing from existing investors—frequently in the form of convertible notes or down rounds that cram down common equityholders. When investor-appointed directors approve such deals, and the resulting M&A significantly benefits those insiders, the situation is ripe for shareholder lawsuits.
- In re Nine Systems Corp. Shareholders Litigation (September 2014) follows this fact pattern and resulted in six years of litigation and over $2 million in damages against conflicted directors and their venture funds.
- See our article for more information regarding potential liabilities for breaches of fiduciary duties in this “down round” context.
- CEO’s Preferred Buyer: A founder-CEO is uniquely positioned to identify the most strategic or financially attractive acquirors. But when personal incentives (like post-sale employment) drive them to favor certain buyers (e.g., by slanting the information reported to the board or assisting the buyer in its bid), it can lead to breaches of loyalty.
- In re Mindbody, Inc. Stockholder Litigation (March 2023) resulted in the CEO being personally liable for ~$40 million in damages for breaching his fiduciary duties in a sale context when he “effectively greased the wheels” for the eventual buyer by giving the board only partial information about conversations with other possible acquirors (among other improprieties).
Mitigating Conflicts: Tools for Companies
While it may not be possible to entirely avoid conflicts, boards can take disciplined actions prior to and during transactions to mitigate their liability and allow transactions to stand up to judicial scrutiny.
A Safe Harbor
Delaware law recently changed to allow boards to avoid breach of fiduciary duty claims due to conflicts of interest if proper procedures are followed. Generally, in transactions posing conflicts of interest with directors/officers or a sale of the company to a non-controlling stockholder, a safe harbor applies to transactions that are approved either by (i) a majority of disinterested directors (potentially acting through a special committee with delegated negotiation authority) or (ii) the uncoerced, affirmative vote of a majority of votes cast by disinterested stockholders. Many startups are hesitant to appoint multiple independent directors to a board or spend the legal fees to have separate legal counsel for a special committee, but given the new legal framework and litigation climate in Delaware, the advantages for doing so are greater than ever.
Other Best Practices
If taking the steps necessary to qualify for the safe harbor is not practical, boards can still follow healthy practices to limit the impact of conflicts of interest, including:
- seeking the advice of legal counsel early and often to craft solutions to limit conflicts;
- fully disclosing conflicts of interest to the board and legal counsel and voluntarily recusing oneself for particularly onerous ones or delegating negotiation authority to board members with less severe conflicts;
- utilizing multiple valuation analyses (including seeking alternative proposals, or even obtaining a fairness opinion or other valuation from an investment bank) in determining whether the price in an M&A or other transaction is fair and in the best interests of common stockholders. There may be scenarios where the fair valuation to common stockholders is $0, but it is best when multiple valuations support this;
- to the extent possible, running a fulsome sale process to ensure that all potential opportunities are identified and considered (in other words, “leave no stone unturned”);
- employing counsel to keep appropriate board minutes to reflect the robust process of deliberation and negotiation described above; and
- maintaining good confidentiality “hygiene” and avoiding selective disclosures of pre-signing transaction information to only a portion of applicable stockholders.
By proactively identifying and mitigating conflicts, founders and directors can reduce litigation risk, protect long-term reputations, and increase the likelihood that critical M&A and financing transactions withstand both shareholder scrutiny and judicial review.