Section Review

I. Introduction
Assume the following scenario: VC1 and VC2 are venture capital firms that have invested in ACME Corp. in a garden-variety first-round venture financing. As a result of the financing, VC1 and VC2 together hold preferred stock representing 30 percent of ACME's outstanding voting stock. The preferred stock terms allow each of VC1 and VC2 to appoint a director to ACME's five-member board of directors; the remaining directors are ACME's two founders and an individual selected by all other directors. The preferred stock terms also give VC1 and VC2 anti-dilution protection and the right to reject any merger or acquisition or any sale of ACME's stock. ACME now needs additional funding in order to avoid shutting down. Given the currently tight investment market, third-party investors are uninterested. Additional funding from VC1 and VC2 is ACME's only option. ACME and VC1 and VC2 decide to negotiate the terms of a "follow-on" financing.

Venture investors and companies in this situation often fail to fully appreciate the ethical issues that can arise in a follow-on financing. Ethical issues arise because directors of corporations (like those appointed by VC1 and VC2) owe certain fiduciary duties to the corporations they serve and all of their shareholders. Additionally, transactions between a corporation and its controlling shareholders often raise issues due to the potential for self-dealing on the part of the controlling shareholders; indeed, controlling shareholders have been found to owe fiduciary duties to non-controlling shareholders in some instances.

This article summarizes certain aspects of directors' fiduciary duties in the context of a follow-on venture financing.

II. Background
New investors typically owe no fiduciary duties to a company in which they invest. Absent some out-of-the-ordinary affiliation, negotiations proceed at arms' length. While one may question the ultimate bargain that management strikes with new investors, allegations of self-dealing generally do not arise. It is under this framework that VC1 and VC2 negotiate the first round of financing with ACME.

Follow-on rounds of financing, however, present ethical issues not present when a company negotiates a round of financing with unaffiliated investors. These issues stem from the combination of the terms of the prior rounds of financing with the duties of the VCs' representatives in their capacities as board members. The scenario outlined above is fairly typical for a first round of venture financing: VC1 and VC2 obtain board representation and together hold a significant block of ACME's outstanding stock (typically 30 percent to 40 percent). The directors designated by VC1 and VC2 are employed by and hold significant equity interests in their respective venture funds. In subsequent rounds of financing, the VCs' ownership percentages would typically increase to where they, together with any subsequent investors, hold a majority of ACME's outstanding stock after a second or third round. Additionally, VC1 and VC2 would typically negotiate for a number of "blocking" rights, meaning rights to block ACME from taking certain actions without these investors' consent. These rights may include the right to block the issuance of additional stock, the amendment of ACME's charter, or any merger, acquisition or sale of ACME. As a result of these terms, VC1 and VC2 will typically have a great deal of control over the most significant decisions made by ACME after the first round of financing.

The VCs' corporate control over ACME gives them significant financial control over ACME as well. Rarely do venture investors expect that the money they invest in an initial round of financing will last until the company grows to a point at which a lucrative exit is attainable. Rather, VC1, VC2 and ACME's management assume that ACME will need one or more additional rounds of financing to get it ready for an exit. Because VC1 and VC2 can usually prevent ACME from taking in cash from sources they do not want, they can effectively dictate when, from whom and on what terms ACME will take in new money. VC1 and VC2 can literally turn on or off the pipeline of cash to ACME. Thus, VC1 and VC2 will have an enormous influence over whether ACME will succeed or fail.

In instances where there are no willing sources of outside investment and ACME must negotiate directly with VC1 and VC2 for additional funding, the VCs' already-strong influence over ACME is significantly increased. An existing investor is generally under no obligation to extend follow-on financing in the absence of an agreement to do so or some other set of unusual circumstances. It may invest or not invest. Further, if an investor is not obliged to extend follow-on financing at all, it should not be obliged to do so on below-market terms. When ACME has no options other than VC1 and VC2, they will be able to dictate the terms on which they will put more money into ACME. Thus, the decision of whether and on what terms to extend follow-on financing rests largely with VC1 and VC2. Once the decision to invest is made, however, the conduct of directors appointed by VC1 and VC2 will be subject to certain legal standards. As discussed below, directors may be held personally liable in some instances for violating these standards.

III. Discussion
A. Fiduciary duties generally
Under Delaware law,¹ the directors of a corporation owe certain fiduciary duties to the corporation and its shareholders. The Delaware Supreme Court has described these duties as demanding of a director "the most scrupulous observance of his duty, not only affirmatively to protect the interests of the corporation committed to his charge, but also to refrain from doing anything that would work injury to the corporation." Weinberger v. UOP, Inc., 457 A.2d 701, 710 (Del. 1983) (quoting Guth v. Loft, Inc., 5 A.2d 503, 501 (Del. 1939)). This fiduciary duty requires that a director be loyal to the corporation and avoid any conflict between his or her duty and self-interest. Id. There are three aspects of a director's fiduciary duty: care (i.e., the duty to inform oneself of all material information before taking action), loyalty (i.e., the duty to act in the corporation's best interests and to not profit at the expense of the corporation) and good faith (i.e., the duty to act in good faith).

All directors of Delaware corporations, including those appointed by specific blocks of shareholders (such as venture investors), are bound by these fiduciary duties of care, loyalty and good faith. See Weinberger, 457 A.2d at 710. A director appointed by venture investors may be subject to competing duties: the fiduciary duties he or she owes the corporation and its shareholders versus any practical or fiduciary duties he or she may owe the limited partner investors in the shareholder that appointed him or her (who have entrusted their investment in his or her care). This conflict, however, does not absolve a director of the fiduciary duties owed the corporation and its shareholders. See id. at 710-711.

Directors may be held personally liable for certain breaches of fiduciary duties. Suits challenging director conduct arise frequently and often name the directors individually as defendants. In many instances, the corporation's charter will allow the corporation to indemnify directors against liability or otherwise eliminate or limit the directors' liability to the corporation or its stockholders. Section 145 of the Delaware General Corporation Law makes clear, however, that a corporation may only indemnify a director in instances where the director has acted "in good faith and in a manner the [director] reasonably believed to be in or not opposed to the best interest of the corporation." Similarly, Section 102 of the Delaware General Corporation Law provides that a corporation may not eliminate or limit a director's personal liability to the corporation or its stockholders arising from actions not taken in good faith or breaches of the director's duty of loyalty to the corporation. Thus, a corporation may not be legally permitted to indemnify or limit the liability of a director in instances where the director has been found to have breached his or her duties of good faith or loyalty. In such instances, and in the absence of applicable insurance coverage or other arrangements, a director may be personally liable for damages. Additionally, in the event that the venture fund which appointed the director is obliged to indemnify the director, the fund itself may be ultimately responsible for paying any resultant damages.

Whether directors have breached their fiduciary duty depends on the facts and circumstances of each situation. The Delaware courts have developed a framework through which they view challenges to director conduct. Delaware courts will apply one of the two following modes of analysis in assessing director conduct, depending on the facts of a given case: the "business judgment rule" or the "entire fairness test".

B. The business-judgment rule
When reviewing the actions of corporate directors, Delaware courts resist substituting their judgment for that of the directors. This resistance stems from the courts' recognition that businesspersons have business experience, skill and judgment that judges usually lack. See In re J.P. Stevens & Co. Shareholders Litig., 542 A.2d 770, 780 (Del. Ch. 1988). When assessing an action or decision of a board of directors, Delaware courts generally presume that "in making a business decision the directors . . . acted in good faith and in the honest belief that the action taken was in the best interests of the company." Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985) (quoting Aronson v. Lewis, 472 A.2d 805, 812 (Del. 1984)). This presumption is known as the "business judgment rule".

The business-judgment rule, however, does not protect director action that is not informed, disinterested, or independent. Id. at 1279. The breach of any one of the three aspects of a director's fiduciary duty (care, loyalty or good faith) may be enough to overcome the business-judgment rule. Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156, 1164 (Del. 1995). That a few directors may have a potential conflict of interest, however, is not necessarily sufficient to overcome the business-judgment rule. Rather, the director interest has to be both material to the director(s) having the interest and significant enough to taint the entire board's decision. Id. at 1168; Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 364 (Del. 1994). A plaintiff asserting a breach of director fiduciary duty will frequently try to make its case by arguing that a majority of the directors have material conflicts of interest or, if fewer than a majority, that these directors were in a position to effectively control the board (perhaps through large shareholdings, blocking rights, voting agreements, or some other means). See, e.g., Kahn v. Lynch Communications Syst., Inc., 669 A.2d 79, 81-83 (Del. 1995); Cinerama, 663 A.2d at 1168; In re Tri-Star Pictures, Inc. Litig., 634 A.2d 319, 322 (Del. 1993); Boyer v. Wilmington Materials, Inc., 754 A.2d 881, 893 (Del. Ch. 1999).

In the context of a follow-on venture financing, the directors appointed by the venture investors have an obvious conflict of interest: their interest in maximizing the returns to, or protecting the investment of, their respective venture funds directly conflicts with their duties of "unselfish loyalty" to the corporation. Thus, the conflict of interest of the directors appointed by venture investors is clear and often material to those individual directors. Whether those directors' interests are sufficiently material that they taint the entire board's decision is a more difficult question. The directors' interests clearly should taint a board's decision if the directors comprise a majority of the board. See Cinerama, 663 A.2d at 1168. If the interested directors are less than a majority of the board, however, the question becomes more tricky.

Where the interested directors constitute less than a majority of the board, to avoid the business-judgment rule the party challenging the directors' action must show that those directors were in a position to control or dominate the board notwithstanding their minority. Cinerama, 663 A.2d at 1168. Where the venture investors that appointed the interested directors hold a majority of the corporation's outstanding voting stock, one may argue that that those directors are in a position to dominate the board by virtue of the majority stockholdings they represent. Additionally, the blocking rights granted to venture investors may be sufficient to give them the power to control the corporation, at least insofar as the corporation's ability to either obtain additional financing or pursue a sale or merger.

Thus, directors of a venture-backed corporation cannot assume that a Delaware court will defer to their decision to approve the terms of a follow-on financing. Rather, if the directors have material conflicts of interest and are in a position to dominate or control the board (through board seats, shareholdings, blocking rights or the like), then a Delaware court may not defer to their decision and may instead look more closely at the terms of the financing. Cinerama, 663 A.2d at 1162; Solomon, 747 A.2d at 1112. This heightened level of inquiry is known as the "entire fairness test".

C. The entire fairness test
Directors who may have a material conflict of interest in a particular transaction bear the burden of demonstrating "their utmost good faith and the most scrupulous inherent fairness" of the deal they strike with the corporation. Weinberger, 457 A.2d at 710. In this instance, a Delaware court will review the transaction and the board's conduct in an effort to determine whether the transaction was fair to the corporation. See id. This test has two basic aspects: fair price and fair dealing. Weinberger, 457 A.2d at 711. The fair-price aspect "relates to the economic and financial considerations of the proposed [transaction], including all relevant factors." Id. The fair-dealing aspect "embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and stockholders were obtained." Id.

The fair-price and fair-dealing aspects of the entire fairness test may be relevant in varying degrees depending upon the facts of a particular transaction. Id.; Boyer, 754 A.2d at 899-900. Payment of a fair price may make up for unfair or abusive conduct in the course of a transaction in many instances. In fact, price may be the most important factor in a merger or company sale. See Cinerama, 663 A.2d at 1163. In other instances, price may be less important relative to the fairness of the dealings among the parties.

1. Fair price
In the context of a follow-on venture financing, the fair-price aspect of the entire fairness test will not likely be determinative, particularly where there are no competing investment offers. Valuing an early-stage corporation is a notoriously difficult task that can result in a wide range of valuations. For example, how does one value untested but promising intellectual property or a management team, both of which are often key assets of early-stage companies?

Additionally, any valuation of a venture investment must take into account the various rights and preferences associated with preferred stock, the market reasonableness of which changes rapidly (as illustrated by the frequency with which companies now accept full-ratchet anti-dilution provisions, something very rare only a short while ago). Even the valuation of large public companies, which by virtue of their market valuations and reporting obligations have objective valuation criteria, is frequently the subject of litigation. When such objective criteria are absent, valuation becomes much more subjective, even arbitrary.

Where there are competing investment offers, one can always weigh those offers against the follow-on terms and try to determine which has the more favorable combination of financial terms and rights and preferences. In the absence of competing investment offers, however, the corporation may have nothing against which to compare the follow-on terms to see if they are more or less reasonable than whatever else is available. In such an instance, the corporation may have to face the reality that, depending on how badly it needs the money, the venture investors may be able to dictate the terms of the follow-on investment. If there's only one offer on the table and the corporation is willing (albeit reluctantly) to take it, then it's difficult to argue that the offer is inherently unfair.

This is not to say that such a transaction as a whole is "entirely fair" to the corporation, but rather that the fair-price aspect of the entire fairness analysis does not by itself end the inquiry. In order to determine if the transaction is entirely fair to the corporation, one must also look at the way in which the transaction was conducted.

2. Fair dealing
If a corporation finds itself on the receiving end of a follow-on investment with onerous, one-sided terms, a natural question is how did the corporation find itself in that position. The fair-dealing aspect of the entire fairness analysis attempts to answer this question. In the context of a follow-on venture investment, the fair-dealing analysis may focus on how the venture investors and the directors they've appointed use their significant power. A court may look for abuses of this power that may have put the corporation in the position of having no choice but to accept unfavorable terms: Did those directors encourage or discourage management's exploration of outside funding opportunities? Did they reject an investment opportunity in the recent past? Were the terms of that investment opportunity more attractive than those the venture investors offered the corporation? In negotiating the follow-on investment, did the directors and their venture backers negotiate in good faith or did they lead management down a primrose path, only to exact onerous terms on the eve of closing? These are the sorts of questions a court might ask in determining whether the interested directors dealt fairly with the corporation.

The resolution of these issues is highly dependant on the facts of a given situation. Comparing the following two scenarios illustrates this point. Scenario 1: the interested directors veto outside financing arrangements in an effort to force a corporation to accept less attractive terms from the current venture investors. Scenario 2: the same third-party investment offer is on the table, but the venture investor-designated directors reject the offer it in the honest belief that a better investment offer is possible. One month later, this better investment offer has not materialized. In fact, the investment climate has changed so dramatically within that month that even the previously rejected terms are no longer available. In the absence of other third-party suitors, the corporation may have no choice but to negotiate with its existing investors, possibly on terms less attractive than those rejected only a month before.

Each scenario ends in the same result: the corporation closes a follow-on financing on terms less attractive than those offered previously by a third-party investor. Notwithstanding the similar result, however, one may draw drastically different conclusions about whether the interested directors and their venture backers dealt fairly with the corporation. In the first case, it appears that the interested directors used their significant power to impose terms on the corporation worse than those the corporation could have obtained from another willing investor. In the second case, the conclusion is much less clear. The directors may be able to establish that their reasons for refusing the original offer were, at that time, sound and in the best interests of the corporation. That their market predictions did not hold true does not necessarily mean that their decision was not reasonable when made. Also, the directors may be able to establish that the terms of the follow-on financing were consistent with those generally available in the market at the time of its closing.

Determining whether the directors and investors have dealt fairly with the corporation is equally fact intensive where there is no willing third-party investor. On the most "fair" end of the spectrum would be a situation in which management negotiates a term sheet with the existing venture investors and closes the financing on those terms. Here the parties have dealt openly with one another, regardless of how onerous the corporation may perceive the terms to be. At the "unfair" end of the spectrum would be a situation in which interested directors negotiate a term sheet with the corporation, allow the corporation's financial position to deteriorate while the investment market weakens, then introduce an array of oppressive terms on the eve of closing. In this instance, the interested directors have not only played a direct role in a situation where they clearly stand on both sides of the deal, but they have also misled the corporation about their intentions with the aim of placing the corporation in a position where it had no choice but to accept unfavorable terms. Depending on the corporation's particular situation, it may have foregone other funding opportunities in pursuit of the follow-on, only to have the terms of the follow-on changed at the last minute.

As the discussion above indicates, application of the entire fairness test to any transaction will depend on the varying facts and circumstances surrounding the transaction. There are, however, some practices that may help investor-appointed directors decrease the possibility that their conduct in a follow-on financing will be successfully challenged.

D. Suggested practices
Directors should exercise care and good faith in assessing all financing opportunities offered the corporation. Should the directors reject a financing opportunity, they should be certain that their reasons for doing so are based on a good-faith analysis of the terms of the offer and the corporation's needs. Additionally, directors should make sure that there is a clear record of their deliberations and their reasons for rejecting the offer. In most cases, the corporation will simply move on to other opportunities. Where another opportunity is not available, however, management and the corporation's shareholders may question the wisdom of rejecting the original offer. Their questions may become louder and more pointed if the existing investors subsequently offer follow-on financing on terms less attractive than those of the rejected offer. In either case, the directors will want evidence that they carefully considered the prior offer and rejected it in good faith and for valid reasons. The investor-appointed directors may want to record a formal vote or resolution on the rejection of the funding opportunity, particularly where disinterested directors voted with them.

Directors appointed by the existing venture investors may want to consider recusing themselves from the negotiation process if there are other representatives of the investors who can negotiate directly with the corporation's management. Where the investor-appointed director is an investor's only representative having an ongoing relationship with the corporation, however, this suggestion may prove impractical. The directors may wish to appoint a special committee of disinterested directors to review and pass on the adequacy of the terms of the financing, as the Delaware Supreme Court has reasoned that the use of a special committee may help approximate an arms'-length bargaining process in the mergers-and-acquisitions context. Kahn v. Lynch Communications Systems, Inc., 638 A.2d 1110, 1121 (Del. 1994) (citing Rabkin v. Philip A. Hunt Chem. Corp., 498 A.2d 1099, 1106 & n.7 (Del. 1985)); Freedman v. Restaurant Assoc. Indus., Inc., 1987 WL 14323 (Del. Ch. 1987). In the context of a venture financing, this tactic may prove less useful in that special committee often would include the members of management negotiating the transaction on the corporation's behalf, plus perhaps an independent director who will vote on the matter when it comes before the board anyway. Nevertheless, recusal by the interested directors may help demonstrate that the corporation and the investors tried to create an arms'-length bargaining process.

Interested directors should also ensure that a majority (and preferably all) of the disinterested directors consent to the terms of the financing. Additionally, Delaware case law indicates that in the context of a transaction between a corporation and its controlling stockholder(s), ratification of the transaction by fully informed non-controlling stockholders may shift the burden of proof to the plaintiffs challenging the transaction. See Solomon, 747 A.2d at 1116-17 (citing Kahn, 638 A.2d at 1117). In the context of a follow-on venture financing, a natural time to seek this ratification would be in connection with the consents necessary to amend the corporation's certificate of incorporation.

Finally, interested directors should encourage existing venture investors to negotiate with the corporation in good faith and to avoid tactics that may appear unseemly. Last-minute changes to the terms of a follow-on financing, even if market driven or made in good faith, may create the appearance of bad faith. This appearance is naturally worsened when the changes are not market driven or come without warning.

IV. Conclusion
Directors appointed by venture investors need to keep fiduciary duties in mind both in assessing whether to extend follow-on financing and in negotiating the financing terms. As a result, they cannot necessarily recreate the earlier process and assume their earlier roles. Directors should tread carefully so as to minimize the possibility that the corporation or shareholders later challenge their conduct.

End note

1. Because most venture-backed companies are Delaware corporations, this article focuses on Delaware law dealing with business corporations (as opposed to other forms of entities). While a significant amount of Delaware case law deals with fiduciary duties generally and in the context of merger and acquisitions, very little specifically relates to directors' fiduciary duties in the context of venture investing. As a result, a great deal of the discussion in this article is drawn from cases of general application or cases occurring in a mergers-and-acquisitions context.[back]