Creating systems, teams, and processes to ensure compliance is the bread and butter by which corporate boards meet their fiduciary duties. Long-standing institutional corporations have largely embedded these imperatives into their DNA to protect against liability and have built internal legal teams to ensure continued compliance. Conversely, meeting fiduciary duties from a corporate governance perspective and financial perspective often appears murky in the expanding arena of hypergrowth venture-backed start-up companies. Successful start-up founders are typically idea-driven individuals who take countless steps to build their businesses from an operational standpoint. As a matter of necessity, company founders do typically manage to get corporate formation documents in place early on to attract or satisfy potential early investors.
Often overlooked, however, is the critical underpinning beneath the documents and organizational forms: Founders have duties as fiduciaries to their companies and investors. By operating a start-up without any awareness of these fiduciary obligations, many founders could be planting land mines in their company’s core documents and putting themselves at risk for costly litigation down the road. Founders, in their roles as directors, managers, executives, and owners, have fiduciary responsibilities to act in the company’s best interest, sometimes to the exclusion of their own best interests. These fiduciary obligations are foundationally based on principles of acting within the highest level of trust and professionalism.
Claims that a board of directors is liable for acts or omissions of a corporation are governed by a common-law formulation of principles of the fiduciary duties of care and loyalty, as well as state law, with a high degree of deference to the case law developed by the Delaware courts. Under Delaware law, directors and officers owe fiduciary duties of due care and loyalty. The duty of due care requires directors and officers to make fully informed, good-faith decisions in the best interests of the company. The duty of loyalty imposes on directors and officers the obligation not to engage in self-dealing and instead to put the interests of the company ahead of their own. But each state has its own corporate governance statutes and case law that specify what a fiduciary is and how one breaches fiduciary duties under the governing law. Thus, founders and their legal counsel must understand the specific laws of the state in which a company is incorporated or organized. Generally, however, most state laws also focus on the foundational fiduciary duties of (1) the duty of care and (2) the duty of loyalty. Recognizing these two duties and what they entail is essential for any founder hoping to raise capital through outside investment. If a shareholder finds that a director or executive has failed to act within his or her fiduciary duties to the company, that shareholder can hold the director or executive personally liable.
Generally, the duty of care comprises the responsibilities of fiduciaries to act in the same manner as a reasonably prudent person would in making decisions for the company. In practice, courts frequently interpret the duty of care as a duty of fiduciaries to stay informed. Namely, directors and executives cannot make decisions with their heads in the sand. Rather, directors must take reasonable steps to gather relevant information or data before exercising judgment. Courts generally give deference to directors and executives when fiduciary breach litigation is brought, recognizing a presumption that fiduciaries exercised sound business judgment in their decision-making and acted in the company’s best interest. This presumption is referred to as the business judgment rule.
The business judgment rule places an incredibly high burden of proof on plaintiffs to discredit the actions of fiduciaries. Many states allow fiduciaries to shield themselves from fiduciary duty claims arising under the duty of care. Thus, companies will typically include in their articles of incorporation or operating agreements provisions that eliminate any liability for breaching the duty of care. But these agreements can be cast aside when conflicts of interest are shown on a company’s board or widespread lack of corporate governance is present, both of which arise from a widespread inattention to corporate governance among high-growth start-up companies and the venture capital (VC) firms that fund them.
Although it appears that some progress has been made through continued development of state law guidance on corporate governance and board constitution in particular, there remains a widespread underappreciation of the scope of fiduciary duties owed by directors in start-up companies backed by VC firms. This concern lies within the ranks of those companies’ directors, especially among directors who are also members of the financing VC firms Not only do these individuals frequently have conflicts of interest, but they also tend to be far more experienced than their board counterparts who are the company’s founders, which creates a perfect storm for abuse and breaches of fiduciary duties. Furthermore, there can be a disconnect between the founders and VC implants on the boards, on the one hand, and the directors who are pulled in from the outside, on the other hand. Thus, start-up companies’ governance can often suffer from a tendency to overgeneralize across companies. This evidently common underappreciation of corporate governance in start-up companies likely stems in part from the lack of training for directors and from the reality that there is simply not as much accountability in private start-up companies as there is in public companies. To be clear, this statement on reduced accountability is not a slam on the start-up culture, but a truism on the lack of regulator-induced pressure and accountability prior to going public.
Many of the issues highlighted in this article were taken up by the Delaware Chancery Court in a 2013 case commonly known as Trados, which involved the sale of a VC-backed company for $60 million. In re Trados Inc. S’holder Litig., Consol. C.A. No. 1512-VCL (Del. Ch. Aug. 16, 2013) (mem. op.) (holding the sale of Trados to SDL was entirely fair to the Trados common stockholders and that the Trados directors had not breached their fiduciary duties in approving the transaction). Although the court in Trados found that the merger’s approval was not a breach of fiduciary duties, the court’s thorough analysis identified brewing conflicts and potential huge future liabilities that could arise from board placements and corporate governance moves that are business-as-usual in VC-backed companies. There, the investor VC firms held a majority of Trados’s preferred stock and were contractually entitled to name four of the company’s seven directors. The VC firms received $52.2 million; members of management (executives hired by the board) received $7.8 million under a management incentive plan; and the common stockholders (including the company founders) received nothing. Trados is noteworthy to start-ups and VC-firms (and perhaps a warning call) for several reasons, the first of which is its evaluation of whether to apply the business judgment rule or the entire fairness standard. As a refresher and overview, the two standards provide as follows:
The rule creates presumption of sound business judgment that may apply if at the time of a transaction’s approval, the board acted on an informed basis, in good faith, and upon a reasonable belief that the action was in the company’s best interest. To benefit from this presumption, however, the majority of the directors must have no conflicting interest in the decision.
Under this standard, the court goes through a head-counting analysis, reviewing the disinterestedness of directors one by one. If the analysis determines that there are not enough disinterested and independent directors to make up a board majority, then the board cannot benefit from the presumed validity of their action under the business judgment rule. Once the entire fairness standard applies, the directors involved must prove that the transaction was the product of both fair dealing and a fair price.
Notably, the entire fairness standard exposes directors and VC funds to potentially extensive litigation and personal liability. This is what makes Trados so noteworthy to start-ups—and certainly to the VC funds that invest in them and serve on their boards. The court applied the entire fairness standard based on a review of the company’s seven directors. Then the court in Trados examined the makeup of the company’s board, noting that the following groups had conflicts:
As a matter of well-settled Delaware corporate law, a director “is considered interested when he will receive a personal financial benefit from a transaction that is not equally shared by the stockholders.” Rales v. Blasband, 634 A.2d 927, 936 (Del. 1993). And, when conducting a fiduciary analysis, the benefit received by the director and not shared with stockholders must be “of a sufficiently material importance, in the context of the director’s economic circumstances, as to have made it improbable that the director could perform her fiduciary duties . . . without being influenced by her overriding personal interest.” Orman v. Cullman, 794 A.2d 5, 22–23 (Del. Ch. 2002) (quoting In re Gen. Motors Class H S’holders Litig., 734 A.2d 611, 617 (Del. Ch. 1999)). Applying these standards to the facts referenced above, the Trados court held that these six of the seven directors were conflicted, and the court found that it was entirely reasonable to believe their approval of the transaction may have been influenced by these material benefits.
After concluding that the Trados board was conflicted, the court addressed the question of to whom fiduciary duties are owed when the interests of common and preferred stockholders conflict. This is sometimes called the beneficiary inquiry. There has some been debate over this question, with competing theories. But, in Trados, the court emphatically endorsed the rule of common maximization, stating that the board owes its primary duty to common stockholders when the interests of the preferred and common come into conflict. The court held that directors owed a fiduciary duty to the common stockholders—calling them “the ultimate beneficiaries of the firm’s value”—not to preferred stockholders, who, conversely, benefit instead from certain contractual arrangements. In this vein, the court decried the Trados board for failing to more vigilantly serve common stockholders. Specifically, the court stated that
defendants in this case 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.
In re Trados, Consol. C.A. No. 1512-VCL, slip op. at 81.
Despite the directors’ failure to follow a fair process and to look beyond special interests as preferred stockholders, the court ultimately concluded that the approval of the merger was fair to the common stockholders because the common stock had zero value at the time of the merger.
Because the makeup of the board in Trados is typical of arrangements in venture-backed companies, this case should be a warning call to VCs and start-ups alike that they have potential huge liabilities if they do not get their corporate governance in order.
Though Trados rang the bell first, a subsequent Delaware case involving director fiduciary duties in venture-backed companies has emphasized the point and made an even greater impression. See Basho Techs. Holdco B, LLC v. Georgetown Basho Inv’rs, LLC, C.A. No. 11802-VCL (Del. Ch. July 6, 2018). In Basho, the same judge from Trados presided and ruled that a VC investor and its designated directors had breached their fiduciary duties by applying improper control in connection with a financing round and with certain post-financing board actions. There, the court held that the VC firm and its designated directors were jointly and severally liable for $20.3 million in damages.
Although these rulings seem to forecast a dreary outlook for VCs and the directors they designate to the boards of their portfolio companies, there is no shortage of prudent measures VC firms and venture-backed companies can take to reduce their potential liability for breaches of fiduciary duty.
As a first step, companies should put an emphasis on keeping contemporaneous and detailed board minutes and on following process-driven methodologies in reaching important decisions. Furthermore, VC firms and VC-backed companies can put their best foot forward to avoid large liabilities like those found in Basho if they acknowledge and operate under the understanding that (i) most venture-backed companies have boards that are conflicted and are not entitled to the benefit of the business judgment rule and (ii) the board owes its primary duty to common stockholders when the interests of the preferred shareholders (typically the investing VC firms) and common shareholders deviate in any material way.
