Five Delaware Cases All Venture Capital Players Should Know

Now and then this blog publishes compendiums of bedrock decisions and key principles of which M&A and Corporate Governance practitioners, and their clients, should be aware.  This post takes the opportunity to highlight five relatively recent and important decisions that have shaped Delaware legal practice and discourse involving venture capital investment.  Counsel representing investors and other players in emerging growth companies should familiarize themselves with this digest.

• McRitchie v. Zuckerberg, 2024 WL 1874060 (Del. Ch. Apr. 30, 2024): Proponents of Modern Portfolio Theory subscribe to the maxim that “prudent investors diversify,” and believe investors can increase returns at lower risk by diversifying their various holdings. In McRitchie, the plaintiff, a proponent of this theory, alleged that the directors, officers, and controller of Meta breached their fiduciary duties by managing the company under a “firm-specific model,” rather than a diversified-investor model, to the detriment of the company’s stockholder base.  Put another way, the plaintiff alleged the defendants managed Meta’s affairs to generate Meta-specific value — in part due to the company’s directors’ significant holdings in the company — at the expense of the “economy as a whole,” thus harming Meta stockholders with diversified portfolio interests.  The defendants moved to dismiss, contending that they appropriately managed the affairs of the company under a firm-specific model, as Delaware law requires.  The Court of Chancery agreed, confirming that “directors of a corporation owe [fiduciary] duties to the stockholders as investors in that corporation”; such duties “run to firm-specific stockholders in their capacities as firm-specific stockholders and not in any other capacities they may have.”  Investors in emerging companies and other ventures ought to take note of this important opinion and its articulation of the foundation for corporate fiduciary responsibility.  As the court noted, this “point is so basic that no Delaware decisions have felt the need to say it.  Fish don’t talk about water.”
• West Palm Beach Firefighters’ Pension Fund v. Moelis, 311 A.D.3d 809 (Del. Ch. Feb. 23, 2024): The validity of certain investor blocking rights, common in venture capital investment agreements, recently came under scrutiny in Moelis (for a lengthier discussion on our blog about Moelis, see here). There, the company’s founder, chief executive officer, and controlling stockholder entered into a stockholder agreement with the company before it went public.  Among other things, the agreement required the company’s board to obtain the founder’s consent before taking or approving certain corporate action; required the board to comprise a majority of directors chosen by the founder; and limited board committee membership by requiring a certain proportion of such membership to be designated by the founder.  A minority stockholder challenged the agreement’s provisions, alleging that it violated Section 141(a) of the Delaware General Corporation Law (“DGCL”), which requires a company’s business and affairs to be managed by its board of directors, “except as may be otherwise provided in [the DGCL] or in its certificate of incorporation.”  The Court of Chancery agreed, noting that, cumulatively, the stockholder agreement infringed upon the board’s right to govern the company’s affairs.  However, the court observed that the challenged provisions would have been valid had they been memorialized in the company’s certificate of incorporation, or even if they were implemented through the distribution of preferred stock carrying voting and appointment rights, since any certificate of designation of preferred stock would become part of the company’s charter as a matter of law.  Moelis serves to remind venture capital investors and their counsel to consider carefully how, and where, preferred stockholder rights, including blocking rights, are created and documented.
• New Enterprise Assocs. 14, L.P. v. Rich, 295 A.3d 520 (Del. Ch. May 2, 2023): Similarly, many venture capital agreements include covenants not to sue. For example, an investor commits capital to a company, and in return, the company’s stockholders grant the investor a contractual right to engage in a transaction or some other action and promise not to sue if and when the investor exercises that right.  In New Enterprise, a group of venture fund plaintiffs with early investments in a company encouraged management to seek a liquidity event.  The company unsuccessfully pursued a sale, and needed capital.  The company then effectuated a recapitalization, whereby the defendant-investor agreed to inject capital into the business in exchange for a new class of preferred stock, but only if (i) all existing preferred stock became common stock, (ii) the venture funds executed a voting agreement requiring them to approve a sale transaction if the company’s board and a majority of preferred stockholders approved such a transaction (sometimes referred to as a “drag-along” sale), and (iii) the venture funds covenanted not to sue for breaches of fiduciary duty, an appraisal, or otherwise, if a drag-along sale was consummated.  Nevertheless, after a sale was recommended and approved, the venture funds asserted breach of loyalty claims against the defendant-investor, arguing, inter alia, that the covenant not to sue was facially invalid.  Although the Court of Chancery concluded the plaintiff failed sufficiently to plead that the covenant was invalid on its face, the court nevertheless declined to dismiss the breach claims, because even facially valid covenants can violate public policy limitations.  Specifically, the court opined that the covenant’s scope stretched “beyond what Delaware law allows” because it insulated the defendant from tort liability predicted on intentional wrongdoing.  This decision confirms that contractual concessions not to sue for breaches of fiduciary duty in connection with a drag-along sale remain enforceable, but only if they are reasonable, narrowly tailored, thoughtfully drafted, and do not preclude redress against intentional bad-faith conduct by preferred stockholders or other controllers.  Put another way, such covenants are subject to long-standing Delaware policy that precludes exculpation of intentional harm to the company and its stockholders.
• Sheldon v. Pinto Technology Ventures, L.P., 220 A.3d 245 (Del. 2019): Venture capital investments often evoke challenges predicated on controller liability — where a stockholder owns more than 50% of the voting power of a corporation, or owns less than 50% of such power but exercises control over the business affairs of the corporation. In Sheldon, this issue was front and center.  There, the Delaware Supreme Court affirmed the Court of Chancery’s dismissal of plaintiffs-stockholders’ allegations that certain venture capital investor defendants, who collectively owned 60% of the company’s stock, constituted a “control group” and breached their fiduciary duties in connection the dilution of plaintiffs’ voting and economic interests in the company as a result of capital raise and financing.  The Delaware Supreme Court confirmed that to sufficiently plead that venture capital investors constituted a control group, a plaintiff must conceivably allege that such investors are connected in a “legally significant way,” such as “by contract, common ownership, agreement, or other arrangement—to work together toward a shared goal.”  The plaintiffs failed to so plead.  Although the venture firms’ voting agreement entitled them to designate a number of directors to the board, it did not require the firms to vote together on any transaction, including the transaction alleged to have caused the dilution of plaintiffs’ economic and voting positions, and including the eventual sale transaction.  Sheldon confirms that venture investors’ rights to appoint directors “does not, without more, establish actual domination or control” of a company’s business and affairs.
• In re Trados Inc. S’holder Litig., 73 A.3d 17 (Del. 2013): Trados is regarded as a landmark decision involving the venture capital space. The case involved a company that obtained venture capital to support a growth strategy that could lead to an eventual public offering, and in return, the venture firms received preferred stock and board designations.  Although the company increased revenue year-over-year, this growth did not satisfy its venture investors, and the board began to consider a liquidity event.  Part of that process included the adoption of a management incentive plan that compensated management if a sale was achieved, even if such transaction returned nothing for the company’s common stockholders.  The board thereafter agreed to sell the company for $60 million.  The stockholder vote approving the transaction was carried by the preferred shares, who controlled a majority voting power on an as-converted basis, and other “friendly” stockholders, such as company management.  As a result of the sale, the preferred stockholders received most of the total liquidation preference to which they were entitled under the company’s certificate of incorporation, and the balance of the sale proceeds funded management’s incentive payments.  The company’s common stockholders did not receive any sale proceeds.  A common stockholder brought claims for an appraisal and for breaches of fiduciary duty against the company’s board, alleging they were obligated to continue to manage the company independently in an effort to generate value for the common stock, rather than approve a sale that benefitted only the preferred stockholders and management.  Following a trial, the Court of Chancery concluded that the sale process was flawed — e.g., the board failed to adopt protective provisions, and pursued an exit strategy without accounting for, or recognizing, conflicts of interest — but it nevertheless concluded that the sale price was “entirely fair” to common stockholders, because the company’s common stock had no economic value.  In other words, the common stock’s appraisal value before the sale was zero, the same amount common stockholders received as a result of the sale.  Although Trados involved a unique set of facts and circumstances, it provides a helpful reminder to companies, backed by preferred investors, when planning and executing a liquidity event.  The Trados board did not appoint a special committee of independent board members to assess, negotiate, and approve a sale, nor did it condition a sale on a majority vote of common stockholders, nor did it obtain a fairness opinion from an independent third party.  Had the board done so, then the sale could well have resulted in business judgment deference, rather than a trial to consider entire fairness.

This post is as of the posting date stated above. Sidley Austin LLP assumes no duty to update this post or post about any subsequent developments having a bearing on this post.