Venture Capitalist Directors Trying To Serve Two Masters

Friday, March 26, 2004

Robert Kraus, Business Law Today, http://

Better Business Management & Planning Practices

Abstracted from: Inevitable Conflicts? When A Venture Capitalist Is A Director
By: Robert Kraus, Village Ventures, Williamstown, MA
Business Law Today - Vol. 13, No. 3, Pgs. 49-53

Overview:
Discusses the inherent conflict when venture capitalists take a board seat with a portfolio company and then owe fiduciary duties to two entities. Suggests the alternative strategy of obtaining observer rights.

Serving two masters.
Venture capitalists face a crossroads when deciding whether to take a seat on the board of a portfolio company. Good reasons motivate the investor to take a seat on the portfolio company’s board. The venture capitalist can advise on strategy, offer referrals to the business and finance community, and be a resource for management. Sitting on the board also accommodates the venture fund in monitoring its investment and enhances the venture capitalists’ stature, which is useful for prestige in future deals. As general counsel Robert Kraus points out, a board member owes primary allegiance to the corporation. Each director’s decision must consider the best interest of all the shareholders. At the same time, venture capitalists who are general partners in a VC fund owe fiduciary duties to the venture fund and the limited partners who invested in it. While in most circumstances the interests of the fund and the portfolio company coincide, that is not always the case.
Selling the company a source of conflict. Conflicts arise when the interests collide. Suppose, suggests the author, along comes an opportunity to exit the investment by selling the portfolio company. The venture fund may be under pressure from fund investors to take the profits from a sale of the entity, but the company may be better off in the long run by remaining independent. This conflict is particularly pronounced if the sale proceeds will go first to preferred shareholders and only the remainder, if any, will go to the common shareholders, and the trauma compounds if the venture fund has ties with the acquiror.

Dealing with down rounds and inside financing.
Another problem for the investor/director arises if the company is forced into a down round of investment, allowing new investors in at a lower valuation than in the previous round. This can, as a practical matter, wipe out the interests of the early investors. The director who represents one of those early investors would be more likely to resist the down round investment, even if it seems necessary for corporate survival. Directors run even greater risks when the company seeks additional financing from its existing shareholders, those who already hold seats on its board. Shareholders who do not invest are significantly diluted by this inside round.

Observer rights and shareholder approval.
Venture investors can achieve most of the benefits of a board seat while avoiding the pitfalls, the author advises, by obtaining observer rights to board deliberations coupled with provisions requiring the preferred stockholders’ consent for all major corporate decisions. Venture investors can thus take action and make decisions with an unambiguous fiduciary responsibility. Some other protective alternatives include: inspection rights to examine the business’s files and records; the right to approve the corporate budget; prompt disclosure of financing discussions; annual meetings of shareholders and regular reports; and the right to fire managers. Useful negative covenants might require that the preferred shareholders approve material corporate actions, such as paying dividends or other distributions, issuing more equity, incurring debt, selling assets, liquidating, or changing the charter.

Abstracted from Business Law Today, published by American Bar Association, Section of Business Law, 750 N. Lake Shore Drive, Chicago, IL 60611.

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