There's a moment in the emergence of the start-up, after some critical mass of investors and employee-owners have bought in, when the founder's interests start to materially separate from the start-up's.FN1
While corporate conflicts of interests are relatively routine, start-ups are somewhat unique in that the persons who hold a large if not majority stake in the company - the founders - typically also comprise the centralized authority - the Board of Directors. Thus, the conventional guard against conflicts of interests - investing decision-making authority in "disinterested" directors - is infeasible. There are no or not enough disinterested directors to vote.
As a consequence, decisions by the start-up's Board often lack the benefit of the business judgment rule (which requires plaintiffs who subsequently sue to prove the Board acted in bad faith - proving negligence or unfair terms is insufficient).FN2 Instead, courts will apply a generalized fairness doctrine as the standard of review of Board actions, a doctrine which presumes that the conflicted directors acted unfairly and places the burden of proof on directors to show fair dealing (and in the case of valuation of the company, fair value).
Many transactions before a start-up Board's consideration raise theoretical conflict of interest issues, so the risk is widely applicable; however, as a matter of practice, the most salient risks occur during a dilutive financing. The "insider led" (i.e., director or major/controlling investor led) down round is particularly risky because such investors have the ability to set the investment terms (so are any financing events which provide some liquidation return for investors (where, for example, insiders might have more information regarding a potential liquidity event than the other shareholders)).FN3
The recommended precautions to guard against subsequent claims of conflict of interest (i.e., suits by disgruntled stockholders) can get pretty technical and each set of facts requires individualized scrutiny, etc., however, two action items will generally reduce the lion's share of exposure:
First, secure approval from all stockholders with full disclosure of terms (with particular detail on the benefits of the financing terms to the controlling investors (i.e., the Board members) and factors that would adversely affect or impact non-participating shareholders) even if such approval is not technically required under previous financing agreements.
Second, specifically in the context of financings, allow for equal participation in, or a rights offering that accompanies, the financing, even if, again, the previous financing documents do not demand it. Shareholders (and sometimes, to a lesser extent, employees with vested options) should be permitted the right to participate in the financing on or participate on substantially the same terms as the inside investors.
FN1.
The manifestation of this separation takes myriad forms, but can include, just by way of illustration, both small events (the use of start up assets for both personal and business purposes or transactions with third parties (leasing of software, rental space, etc.) in which the founder has some business stake) and large (authorizing or not authorizing an acquisition in order to keep one's job).
FN2.
California and Delaware statutory laws protect a board of directors so long as the relevant transaction was either (i) approved by a vote of disinterested directors or special committee, (ii) approved by a vote of the disinterested stockholders, or (iii) even in the absence of approvals, the transaction was fair and reasonable at time it was authorized by the Board. The benefit of the approvals, note, is that the transaction doesn't have to be fair and reasonable, so long as the proper approvals were secured. Note further, however, that under respective state laws, failure to secure approvals coupled with a finding the transactions was not fair and reasonable leads to PERSONAL liability (which is a serious matter given that most private start ups do not carry D&O insurance).
FN3.
The disclosure issue is a relatively transparent issue of insider trading but the self dealing issue is slightly opaque. Another way to see it is to consider how readily an insider led "down round" can be used as a pretext to dilute other stockholders. Directors and majority stakeholders would always profit from a down-round in which they but no one else participated, because in the absence of any true arms length negotiation they could price the round at a very low price, invest a small amount of capital and come out with a huge portion of the equity.
While corporate conflicts of interests are relatively routine, start-ups are somewhat unique in that the persons who hold a large if not majority stake in the company - the founders - typically also comprise the centralized authority - the Board of Directors. Thus, the conventional guard against conflicts of interests - investing decision-making authority in "disinterested" directors - is infeasible. There are no or not enough disinterested directors to vote.
As a consequence, decisions by the start-up's Board often lack the benefit of the business judgment rule (which requires plaintiffs who subsequently sue to prove the Board acted in bad faith - proving negligence or unfair terms is insufficient).FN2 Instead, courts will apply a generalized fairness doctrine as the standard of review of Board actions, a doctrine which presumes that the conflicted directors acted unfairly and places the burden of proof on directors to show fair dealing (and in the case of valuation of the company, fair value).
Many transactions before a start-up Board's consideration raise theoretical conflict of interest issues, so the risk is widely applicable; however, as a matter of practice, the most salient risks occur during a dilutive financing. The "insider led" (i.e., director or major/controlling investor led) down round is particularly risky because such investors have the ability to set the investment terms (so are any financing events which provide some liquidation return for investors (where, for example, insiders might have more information regarding a potential liquidity event than the other shareholders)).FN3
The recommended precautions to guard against subsequent claims of conflict of interest (i.e., suits by disgruntled stockholders) can get pretty technical and each set of facts requires individualized scrutiny, etc., however, two action items will generally reduce the lion's share of exposure:
First, secure approval from all stockholders with full disclosure of terms (with particular detail on the benefits of the financing terms to the controlling investors (i.e., the Board members) and factors that would adversely affect or impact non-participating shareholders) even if such approval is not technically required under previous financing agreements.
Second, specifically in the context of financings, allow for equal participation in, or a rights offering that accompanies, the financing, even if, again, the previous financing documents do not demand it. Shareholders (and sometimes, to a lesser extent, employees with vested options) should be permitted the right to participate in the financing on or participate on substantially the same terms as the inside investors.
FN1.
The manifestation of this separation takes myriad forms, but can include, just by way of illustration, both small events (the use of start up assets for both personal and business purposes or transactions with third parties (leasing of software, rental space, etc.) in which the founder has some business stake) and large (authorizing or not authorizing an acquisition in order to keep one's job).
FN2.
California and Delaware statutory laws protect a board of directors so long as the relevant transaction was either (i) approved by a vote of disinterested directors or special committee, (ii) approved by a vote of the disinterested stockholders, or (iii) even in the absence of approvals, the transaction was fair and reasonable at time it was authorized by the Board. The benefit of the approvals, note, is that the transaction doesn't have to be fair and reasonable, so long as the proper approvals were secured. Note further, however, that under respective state laws, failure to secure approvals coupled with a finding the transactions was not fair and reasonable leads to PERSONAL liability (which is a serious matter given that most private start ups do not carry D&O insurance).
FN3.
The disclosure issue is a relatively transparent issue of insider trading but the self dealing issue is slightly opaque. Another way to see it is to consider how readily an insider led "down round" can be used as a pretext to dilute other stockholders. Directors and majority stakeholders would always profit from a down-round in which they but no one else participated, because in the absence of any true arms length negotiation they could price the round at a very low price, invest a small amount of capital and come out with a huge portion of the equity.
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