How can a board decrease litigation risk in an insider-led down round or dilutive financing?
Takeaway: In an insider-led down round, where conflicts of interest are inherent, the board's best defense against future lawsuits is a clean, independent process that includes a formal valuation, approval by a special committee of disinterested directors, and a "cleansing" vote from the minority stockholders.
A down round financing is already a high-stakes event. But when that financing is being led by your existing investors—so-called "insiders"—the legal risk for the Board of Directors skyrockets. This is an "insider-led down round," and it is one of the most legally perilous situations a board can face.
The problem is a fundamental conflict of interest. The investor directors on your board are on both sides of the deal. In their capacity as directors, they have a fiduciary duty to all stockholders (including the common stockholders). In their capacity as investors, their fund is leading a financing that will be highly dilutive to those same common stockholders. This conflict creates a high risk of future lawsuits from common stockholders who feel the deal was unfair.
To protect itself and the company, the board must run a meticulous, independent, and defensible process designed to prove that the transaction was entirely fair to the common stockholders.
The Playbook for a Defensible Process
Delaware courts have laid out a clear path for a board to protect itself in these conflicted situations. The goal is to simulate an arms-length negotiation.
Establish a Special Committee of Independent Directors: The first and most critical step is to form a special committee composed solely of the board's independent or disinterested directors—those who do not have a financial interest on the investor side of the deal. This committee is then empowered to evaluate, negotiate, and approve the terms of the financing on behalf of the company.
Obtain an Independent Third-Party Valuation: The special committee should hire its own independent valuation firm to provide a formal "fairness opinion" on the valuation of the company. This provides objective, third-party evidence that the low price of the down round is not an arbitrary number set by the insiders, but is a fair reflection of the company's current value.
Consider Alternatives: The committee must be able to show that it considered other potential financing options before accepting the insider-led deal.
Secure a "Cleansing" Stockholder Vote: This is a crucial final step. The board should seek the approval of a majority of the minority stockholders. This means the deal must be approved by a majority of the disinterested common stockholders, separate from any vote by the preferred stock investors who are participating in the deal. This stockholder vote "cleanses" the conflict and is a powerful defense against any future claim that the deal was unfair.
By creating a robust and independent process, the board can demonstrate to a court that, despite the inherent conflict of interest, it fulfilled its fiduciary duties and negotiated a deal that was fair to the company and all of its stakeholders under difficult circumstances.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.