A Brief Look Back
In April 2000, I stood in the "cafe section" of the financial printers, taking a quick break from getting a registration statement on file for an IPO, and watched CNN report market developments that we would all later recognize as the beginning of the end—what we now refer to as the "bursting of the bubble." Inside the bubble, safe for the moment, the young man next to me watched the report briefly, and then asked innocently, "Is there any more shrimp?"
Where is he now? Certainly not working for the same investment bank, and probably not for any investment bank. In fact, he is probably long gone from Silicon Valley. Neither of us knew, then, that we would so quickly go from wondering, "Will this ever end?" as we did deal after deal, at an inhuman pace, to wondering, "When will it come back again, even a little?" as we did no deals and said goodbye to co-workers and clients, at an inhuman pace.
The years 2001 and 2002 in the venture capital world were marked by constant board meetings to decide how to keep the companies going for just one more week, followed by down rounds, washout financings, recapitalizations, assignments for the benefit of creditors, and just quietly closing the doors. For a time, seasoned investors looked for ways to put in additional capital and still, somehow, write off their prior investments at lofty valuations.[i]
It was the time of the draconian term sheet—replete with 10x liquidation preferences, board shift provisions and "drag along" rights to force a sale of the company at the discretion of the new investors. Creative equity structures were fashioned to reward those employees who remained with the company until sale, despite a mountain of preferred stock liquidation preferences that would ordinarily leave common stockholders with nothing.[ii] Officers and directors worried about personal liability associated with keeping employees in place in the hope that funding would come, knowing that payroll wasn't there if it didn't. They also worried about WARN Act liability if the company terminated significant numbers of employees on shorter than 60 days' notice. Lawyers counseled their clients, both companies and venture funds, on the risks attendant to these transactions—potential liability of officers and directors to creditors and stockholders being left behind—and worried that the legal opinions that were once standard would expose their firms to liability.
How did this happen and how did it differ from the economic downturns of the past? The creation of seed funds, the growth in the number and size of traditional venture funds, the need to put greater amounts of capital to work in each deal, the competition for "hot" deals and the rise of strategic corporate investor funds changed the traditional dynamic. Seed investors didn't have the additional funds to invest nor did they have the connections to assist the company in securing follow-on investments from other funds. Venture funds, seeing the immediate upside of an early IPO, didn't bring in other investors to spread the risk and then were reluctant to take on more risk alone. Corporate funds were not always focused on traditional investment returns, instead reaping rewards through related commercial agreements or gaining visibility into emerging technologies. They never intended to invest in more than one round. The result was chaos when the market turned.
The risk profile had changed dramatically from the old days: Traditional institutional lenders had become more aggressive in their lending policies, leaving companies with real debt to deal with in addition to venture capital investors. The substantial infusions of capital had enabled startups to hire hundreds of employees, and the demand for office space had driven up rents, particularly in Silicon Valley, to outrageous levels. The combination of factors led to very high burn rates that couldn't easily be scaled back. The disparate investment objectives of venture capitalists and strategic corporate investors further complicated the landscape, as strategic investors withdrew from investing completely or required substantial business concessions as a condition to further investment. Management teams tried to broker transactions that would satisfy the seemingly irreconcilable objectives of early stage investors, the last round of investors, potential investors, strategic partners and lenders. Many management teams lacked experience and suffered from less mentoring from their investors, many of whom were equally inexperienced and virtually all of whom who were spread too thinly over too many investments.
No one had time to look at new investments because they were so busy dealing with the old ones, as well as facing limited partners who were beginning to see the writing on the wall. Venture funds added to their internal staff just to monitor their ailing investments. The slowdown in tech spending meant that even those companies with completed products could not generate sufficient revenue to sustain themselves without more capital. No revenue meant that bankruptcy was not a viable option. Many investors concluded that these technologies would be outmoded by the time the market for products returned, and set their sights on new investments in early stage companies that would bring new products to market when there were once again customers to buy them. At some point, it became the conventional wisdom that eighty percent of the portfolio companies funded at the height of the bubble would not survive, and then it was just a matter of waiting to let it all happen—like turning on the morphine drip for a terminally ill patient.
In the wake of the Atlantec[iii] decision, much was made of the potential for litigation by disgruntled (i.e., washed out) preferred investors and founders against venture funds once the salvaged companies rose from the ashes. However, companies and investors rather quickly improved the form and procedure, if not the substance, of their investments, obtaining third-party valuations and/or disinterested stockholder approval, and forming special committees of interested directors to take advantage of the safe harbors against presumed void or voidable transactions between companies and their directors.[iv] The occasional complaint has been filed, alleging to date, the feared onslaught of litigation has not materialized to any meaningful degree.[v] In many cases, new investors sought and received indemnification from the company in the event of any stockholder or third-party litigation involving the investment. Counsel was careful to carve out from its opinion issues of fiduciary duty, fairness of the transaction and compliance with the safe harbor provisions of the applicable state corporate law. The legal costs of completing these transactions skyrocketed. Today, many investments have been written off and the surviving companies can expect to undergo significant recapitalizations in connection with new infusions of cash.
Benchmark Capital v. CIBC—Drafting Matters
One case that reflects many of the foregoing market forces but also provides some enduring value as a drafting lesson for practitioners is Benchmark Capital.[vi] Benchmark was the initial venture investor in Juniper Financial Corp., a financial services company, investing $20M in the Series A round in June 2002. In August 2002, an additional $95M was raised in the Series B round and Benchmark participated with a $5M investment. Thereafter, Juniper needed to raise additional capital and was facing significant difficulties in doing so. Ultimately, the company accepted a $145M investment from Canadian Imperial Bank of Commerce (CIBC) after discussions of a potential acquisition by CIBC terminated. CIBC drove a hard bargain, receiving Series C stock with "full ratchet" anti-dilution protection. The Series A and Series B Preferred were relegated to a junior position. As might be expected, holders of the Series A and Series B negotiated for, and received, certain protective provisions with respect to their junior preferred shares: [namely, the right to approve, voting as a separate class,] (i) any amendment to the charter that would materially adversely change the rights, preferences or privileges of the junior preferred, (ii) any sale of substantially all of the company's assets, consolidation or merger (other than any merger with a wholly-owned subsidiary), and (iii) any authorization or issuance of additional equity securities ranking senior to or on a parity with the junior preferred. In an unusual (and presumably heavily negotiated) provision, CIBC retained the right to waive these voting rights of the junior preferred, provided that CIBC would not be able to exercise this right "if such amendment, waiver or modification would . . . diminish or alter the liquidation preference or other financial or economic rights" of the junior preferred stockholders or would shelter breaches of fiduciary duties. The financing also resulted in CIBC having the right to elect a majority of the company's board of directors.
Benchmark asserted that it consented to the foregoing terms based on representations from CIBC and Juniper that the company would not need additional capital following the Series C round. Nevertheless, Juniper subsequently found itself in desperate need of additional capital and CIBC as the only realistic source. A special committee of independent directors was formed to review and negotiate the CIBC proposal for a Series D round of financing, the proposed terms of which would wash out the Series A and Series B Preferred stock: in exchange for $50M, CIBC would receive Series D Preferred Stock, the junior preferred ownership interest would be reduced from 29% to 7% and the aggregate liquidation preference on the junior preferred would be reduced from $115M to $15M.
The court noted the uncontested fact that without the financing, Juniper would be liquidated and the junior preferred stockholders would receive nothing. CIBC, apparently realizing that the junior preferred (who had nothing to lose but little to potentially gain by approving the CIBC proposal) would be unlikely to consent to amend the charter to authorize the issuance of the Series D Preferred and implement the proposed changes to junior preferred, instead structured the transaction as a 100-for-1 reverse stock split of the common stock followed by a merger of the company with a wholly-owned subsidiary. In the merger, the charter of the surviving corporation (Juniper) would be amended to create the new Series D Preferred and each share of the existing Series A Preferred and Series B Preferred would be converted into a share of the new Series A Preferred and Series B Preferred (bearing the reduced liquidation preference and other changes) plus a fraction of a share of common stock and a warrant for a fraction of a share of common stock. Benchmark sought to enjoin the merger, arguing that the transaction violated the protective provisions of the charter.[vii] The company disagreed, arguing that (i) the protective provisions did not apply to mergers and (ii) in any event, CIBC would have the power to waive the protective provisions for the proposed transaction.
As to the first point, the court agreed with Juniper, noting that the language of the protective provisions in the charter was derived from Del. C. §242(b) relating to rights, preferences and privileges that are subject to Change by a certificate of amendment, and not the standards of Del. C. §251 relating to charter amendments in the context of mergers. The court cited the decision of the Delaware Supreme Court in Elliot Assocs., L.P. v. Avatex Corp.,[viii] which clearly places the burden on the drafter to specify that the protective provisions of §242(b) apply in the case of a merger, with specificity. "To protect against the negative effects of a merger, those who draft protective provisions have been instructed to make clear that those protective provisions specifically and directly limit the mischief that can otherwise be accomplished through a merger under 8 Del. C. §251"[ix] (footnote omitted).
Having dispensed with the issue of the changes to the rights of the Series A and Series B Preferred, the court moved on to the rights of the new Series A and Series B Preferred to a class vote to approve the issuance of the Series D Preferred, and the limited right of CIBC to waive that voting right. The court focused on two issues: First, the court considered the plaintiff's argument that the junior preferred had a voting right with respect to the diminution of the liquidation preferences of the junior preferred that could not be waived by CIBC. The court concluded that the changes to the liquidation preferences would be accomplished through the merger, not through the issuance of the Series D Preferred, and therefore the junior preferred stockholders did not enjoy voting rights pursuant to the applicable provision of the charter. Second, the court considered whether the issuance of the Series D Preferred would diminish or alter the financial or economic rights of the junior preferred thereby giving the junior preferred a voting right that could not be waived by CIBC. The court noted the established precedent that mere issuance of a security that has priority over another security does not adversely affect the preference or special rights of a junior security, but also considered whether the application of that principle to the case at hand would limit the rights of the junior preferred more narrowly than intended by the parties. The court acknowledged that the scope of the exception to the CIBC waiver right was ambiguous, but ultimately rejected Benchmark's argument that the voting right claimed by the plaintiff existed by implication, finding that the plaintiff had not sustained its burden of proof of likelihood of success on the merits to justify the injunction requested. Again, the court placed the burden on the drafters of preferred stock provisions to be explicit in their terms.
The Benchmark decision is a useful reminder that, notwithstanding an established course of dealing or "standard provisions" in venture capital financings, the courts will strictly apply the principle that the terms of preferred stock must be clearly stated in the charter. One can infer that the investors in Benchmark did not anticipate that the parent-subsidiary merger exception in the charter would become a vehicle for a dilutive financing, but the court declined to look to the other provisions of the charter to infer that the parties intended that the Series A and Series B stockholders would in all cases have a right to approve transactions that would reduce their liquidation preferences or otherwise impair their economic rights. While "no impairment" clauses, broadly drafted, may be a useful device to ensure the benefit of the investor's bargain, the courts cannot be counted upon to infer that which the parties could be expected to state explicitly.[x]
Please see Section 10.14.3.a for continuation of this article.
Deborah Marshall is a director at Howard Rice Nemerovski Canady Falk & Rabkin, A Professional Corporation, in San Francisco, California. She gratefully acknowledges the invaluable assistance in the preparation of this article provided by Sarah Good and Annette Hurst, directors, and David Tang, an associate, at Howard Rice, and David Prahl, a law student at the University of California at Davis.
[i] This was a difficult task because the venture fund agreements often precluded two funds under the same management from investing in the same portfolio company (designed to prevent using the new fund to bail out the investment of the old fund).
[ii] For a discussion of change of control provisions as a management incentive tool, see Marshall, Acquisition Carve-Out Plans for Private Companies, Practicing Law Institute, 34th Annual Institute On Securities Regulation, (vol. 2) 285 (2002).
[iv] For an excellent summary of fiduciary duties in the context of washout financings, see Mo, Recent Trends in Venture Capital Financing Terms, Practicing Law Institute, 33rd Annual Institute On Securities Regulation, (vol. 1) 1137 (2001).
[v] See Jonathan Shapiro v. Sanera Systems Inc.; Alex Mendez; Raj Cherabuddi; Charles Chi; Gordon Hull; Bill Stensrud; Does; Enterprise Partners; Greylock Ventures; Storm Ventures; CMEA Ventures; Arrowpath Venture Capital; Goldman Sachs & Co.; Warren Lazarow, (9/10/2003 CGC-03-424318 (San Francisco Super. Ct.) (complaint for securities violations and breach of fiduciary duty claiming an unfair attempt to "wash out" the plaintiffs' ownership in Sanera through a highly dilutive round of new financing, that if successful, will deprive the plaintiff of his rights to invest and the value of his earlier investment in the company), and Aamer Latif, an individual v. Nishan Systems, Inc., a CA Corp; Lightspeed Venture Partners, a CA Partnership; ComVentures, a CA Partnership; Credit Suisse First Boston LLC (CSFB), a Delaware Corp.; McData, a Delaware Corp.; Gill Cogan, an individual; Roland Van Der Meer, an individual; Robert Russo, an individual; John McGraw, an individual (9/11/2003 1-30-CV004939, Santa Clara Co. Super. Ct.) (complaint for declaratory and injunctive relief, alleging that defendants had exclusive knowledge of the unconscionable terms of the bridge loan offered and consummated by defendants Lightspeed and ComVentures and the pending merger negotiation with McData and knowingly concealed these matters from the other board members and Nishan shareholders).
[vi] 2002 WL 31057462 (Del. Ch.), affirmed 822 A.2d 396, 2003 WL 1904660 (Del. Sup.).
[vii] Benchmark also challenged the independence of one member of the committee, as well as the authority and performance of the special committee, but those arguments were not advanced in the motion for preliminary injunction, and appear to have not been subsequently litigated by the parties.
[viii] 715 A.2d 843, (Del. 1998).
[ix]Benchmark, supra, n.6, at 11.
[x] The Benchmark decision has also given rise to concern among some practitioners regarding the "standard" provision that a merger will be treated as a liquidation for the purposes of preferred stock liquidation preferences.