The routine practice of venture capital funds appointing directors to the boards of corporations in their portfolio is generally advantageous to the company, its shareholders and other investors. But while an early-stage startup benefits from the sophistication, experience and network of the seasoned directors designated by venture funds, it also creates risk of liability with structural conflicts of interest under Delaware corporate law.
The law doesn’t recognize a special duty held by directors to any special class electing them. Although the venture fund-nominated director has a natural affinity for the fund’s economic interests, a director owes a fiduciary duty exclusively to the common shareholders, not to holders of preferred stock, warrants or convertible debt. That representative is then put in the difficult situation of putting the common shareholders’ interests—usually the founders, angel investors and employees—ahead of the venture fund.
There’s not usually a conflict when the company is wildly successful or a complete bust: the interests of all classes of investor rise and fall together. The middle ground is trickier – when a company’s growth isn’t steep enough, a venture capitalist looking for a quick winner will prefer to cut its losses, liquidate its investment and target the next prospect for a 10-fold return in five years.
The director’s legal duty is to the common shareholder in the long term, requiring a course that ignores fixed investment horizons. The board has no fiduciary duty to maximize current market value or facilitate the venture fund’s exit.
The structure of the typical venture capital investment can put the conflict into stark relief: Venture funds’ traditional investment in preferred stock with a liquidation preference, which often entitles them to a multiple of their initial investment in case of a buyout, can be highly-dilutive to common shareholders.
In addition, the venture capitalists usually invest in stages, or successive financing “rounds,” as the company requires additional funds to execute its business plan. When a director’s venture fund purchases preferred shares in follow-on funding rounds, the two types of investors come into direct conflict, as preferred-stock holders’ liquidation preference favors a low valuation and high multiple, while common shareholders want the classic incremental growth of the opposite. Common shareholders may claim the venture fund designated director breached the fiduciary duty to common shareholders by providing unfairly generous terms to the venture fund to the detriment of common shareholders.
The venture fund risks being drawn into shareholder litigation under the theory that the fund “aided and abetted” the breach of fiduciary duty by its designee director. This litigation is more difficult to defend than garden-variety claims against corporate directors because the business judgment rule, a judicial presumption which protects directors from liability for good faith mistakes, does not apply in the conflict of interest context. Corporations also can’t indemnify directors against personal liability for breach of the duty of loyalty under Delaware law.
Venture funds and their representatives on the board can take action to limit their risk of liability. Ideally, a board should contain several truly independent directors who are not beholden to the venture funds or management. Those directors can act as a special committee to bargain on behalf of the company and common shareholders in conflict situations. Boards can engage an outside valuation expert to advise on the fairness of future financing rounds, including prevailing market terms. If that is not practical or affordable, the board should clearly document the basis for the pricing of any subsequent financing round and provide an opportunity for management and the founders to provide input. Common shareholders should be allowed to participate equally in any subsequent financing rounds. Finally, the board may seek approval from a majority of the disinterested common shareholders after adequate disclosure.
In cases where the venture fund is not part of a control group, the fund can accept an observer position which entitles its designee to participate in all board deliberations without an actual vote, instead of a fully privileged board seat. A board observer does not owe any fiduciary duty, insulating the fund from any potential liability; the venture fund may rely on the contractual provisions in its investment documents for protection.
The venture fund can also organize the company as a Delaware limited liability company rather than a corporation to mitigate risk. The Delaware LLC statute, unlike the corporate statute, expressly authorizes the members of an LLC to modify by contract the director’s fiduciary duty to more closely align with the real world expectations of venture capital investors.
Gardner Davis is a partner and corporate lawyer with Foley & Lardner, where he advises boards of directors and special committees in regard to fiduciary duty issues in various contexts. Neda Sharifi, Ph.D., is an associate at the firm, and she focuses her practice on corporate and securities law matters, including mergers and acquisitions and securities law compliance counseling.
This article was originally published in Corporate Board Member. Click here for the original article.