Insight Recent Delaware Case Highlights Important Conflict Between VC Directors and Common Stockholders

Recently, the Delaware Court of Chancery found that the board of directors of Trados Incorporated (Trados) did not breach their fiduciary duties when they approved a change of control transaction in which the common stockholders received no consideration. The opinion highlights an important conflict between directors designated to serve on the board by stockholders with preferred distribution rights and the common stockholders with subordinate distribution rights. Read the opinion here.

Trados was controlled by venture capital (VC) investors with preferred stock with liquidation preferences. The VC investors also designated the individuals who controlled a majority of the board. As Trados struggled, the board considered many options, but none appeared to offer any meaningful return for the stockholders. Eventually the board sought an exit for the stockholders and accepted a $60 million offer from SDL that netted management $7.8 million under a management incentive plan, preferred stockholders a distribution of $52.2 million (almost satisfying in full their $57.9 million total liquidation preference), and common stockholders zero. The plaintiff, a common stockholder owning 5% of the company, alleged that Trados directors had breached their fiduciary duties in approving the transaction and sought appraisal.

According to the court, directors that are designated by preferred stockholders with preferred liquidation rights have an inherent conflict of interest in relation to their fiduciary duties to act in the best interest of the common stockholders. Simply put, the risk tolerance of the preferred stockholders with preferred liquidation rights can vary greatly from the risk tolerance of common stockholders who are the “residual owners” of the company. Typically VC directors, and the VC investors they represent, want an exit and they are more inclined to sell at a lower value that nets some consideration, whereas common stockholders seek riskier plays in an effort to grow equity beyond the liquidation preference. Otherwise, a sale of the company may not return any value to the common stockholders.

The court determined that although the process was not fair (there appeared to be little, if any, thought given to the interests of the common stockholders), the price was fair, and, therefore, the directors did not breach their fiduciary duties to the common stockholders. So how can zero be fair? It all goes back to risk and likely return on investment. The court found that although Trados had some risky options to continue operating, “it did not have a realistic chance of generating sufficient return to escape the gravitational pull of the large liquidation preference and cumulative dividend.” Therefore, the common stock had no economic value and zero was a fair price.

Although the Trados directors were ultimately found not to have breached their fiduciary duties, directors should generally not rely on the “zero is a fair price” argument. There are several important lessons for directors to take away from the Trados case, including:

• In evaluating a sale, directors should consider the interests of all stockholders, including common stockholders, and if they ultimately determine to approve the sale, directors should conclude that the sale will generate consideration for the stockholders in excess of what the company would otherwise generate for the stockholders over the long term.
• Directors should take care to document their deliberations, especially their evaluation of all the available options and the cost-benefit to the various stockholders with different risk-reward profiles.
• Zero may be a fair price, but don’t expect your common stockholders to go quietly into the night.

At Hawley Troxell we advise corporations of all sizes and their boards of directors with respect to a wide variety of corporate issues, including debt and equity capitalization, preferred-common stockholder deliberations, and strategic mergers and acquisitions. Please do not hesitate to contact our Business Group or call 208.344.6000.