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Who's Looking Out for You?

Dave Broadwin of Foley Hoag's Emerging Enterprise Center has an interesting blog post about the legal aspects of a company director's fiduciary responsibility.

The key to this issue is that VC investors who take Board seats at small companies have an inherent conflict.  As a partner in a venture fund with compensation tied to the performance of that fund, they are financially motivated to maximize the value of their investment in the company.  As a corporate director, they have a fiduciary responsibility to look out for all the stakeholders in the company.  And, as the Trados case indicates in Dave's blog post, corporate directors should be leaning in favor of looking out for the common shareholders over the preferred.  The preferred shareholders have their rights defined in their stock purchase agreement and, from what I understand of the Trados decision, don't need the additional protection of directors looking out for them.

This creates an obvious conflict, particularly when a company is facing tough times.  What if a company is struggling but has an opportunity to raise money on terms that may be adverse to the existing preferred shareholders?  You can imagine a scenario where, as a Director, a VC votes in favor of this tough financing as it preserves some value for the common stock but, as a preferred shareholder, they vote against it.  That may meet the fiduciary obligations defined in the legal precedent, but sets up weird dynamics.  It's difficult for one person to have two points of view.

What is more likely is that a conflicted director will steer the company away from such a financing because they know that as a shareholder they can't support it.  Is that protecting the interests of the common shareholders?  Unclear.  I was involved in one company that during the 2001 meltdown had to raise an inside round of financing.  It was on tough terms and was structured to motivate existing investors to participate -- put more money in, and you can keep more of what you already have.  Don't put more money in, and you get wiped out (if you are interested in more of the mechanics behind these types of things, say so in the comments.  I'll explain).

One of our large investors made it clear that they had no more money for this deal on any terms.  They were a buyout firm that had been trying their hand at early stage VC.  It wasn't a good fit, and the meltdown confirmed this.  But, even though they weren't going to invest, they were also going to block any sort of financing that diluted their interest.  They were willing to let the company go in order to protect their interest that, without additional financing, would be worth nothing.

We had very complicated discussions at the Board level where each of the VCs was probably thinking more about their firm's stake than about what protected the common shareholders.  Luckily, we were able to convince this firm to let us go ahead with the financing as they were going to get zero one way or the other, unless they changed their mind and participated.  But, the conflict of interest didn't feel good.

Although it's good to have the legal aspect of the conflict clarified -- directors need to protect the common shareholders regardless of what class of stock they hold themselves -- I don't have a good answer for the human side of these conflicts.  The best advice to an entrepreneur is to make sure you go into business with investors and directors who you know, from their past track record, will balance the best interests of the common with their own financial best interests.

Another take on this comes from one of the favorite sayings of one of my former partners (unclear whether the original source of this is John Doerr or Dick Kramlich):

No conflict, no interest!

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