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NEW YORK (Reuters Breakingviews) - Favoring antsy venture capitalists could be asking for trouble. Cashing out these early financial backers of fledgling firms on demand can leave longer-term investors in a lurch. A case involving onetime dot-com darling Oversee.net and Oak Hill Capital suggests some judges find the practice potentially disloyal to startups and their owners. It’s an overdue warning about the damage such conflicts of interest can cause.
The mischief involves preferred stock, the widespread form of equity that gets first dibs on dividends or proceeds from the liquidation of a company. Some investors also relish its debt-like aspects, because companies agree by contract on making payouts, redeeming shares or providing other special treatment.
Investors who seed or invest in tech firms with fast-growth prospects can specify how and when they get paid and when their stakes must be bought out. They also lay claim to any assets if trouble strikes, after debt is paid. Venture capitalists and startup boards have a habit of forgetting that preferred stock is still just equity, and its holders are entitled to receive money only to the extent the company can reasonably pay it. Coerced payments can put bosses at odds with their duties to other shareholders.
This issue caused a stir at trial four years ago, in a lawsuit involving Trados. The translation-software firm initiated a modestly successful expansion that ended with its $60 million sale in 2005. The VC firms involved got a sizable return on their preferred shares, but the common stockholders were left with nothing. One of them sued, claiming the board breached its duty to him and his fellow owners by not considering the upside of keeping the company in business.
Delaware Vice Chancellor Travis Laster agreed that the board had acted unfairly. He also decided, however, that the common stock was worthless before the merger, and so its owners had little to complain about. His unexpectedly strong support for shareholder rights – even to the detriment of the preferred holders – shook up the investing world.
It was mere prelude, though, for another case now working its way through the Delaware courts. It involves Oversee.net, a once-thriving domain-name registrar that hosted events at the Playboy Mansion, including an infamous party where dozens of guests were sickened by a form of Legionnaire's disease.
Acquisitions helped propel Oversee.net, which grew to generate $200 million of revenue and almost $20 million of net income in 2007. The following year, Oak Hill invested $150 million in ODN, a holding company for Oversee.net created to facilitate the financing. In exchange, Oak Hill received preferred stock with a mandatory redemption right exercisable in 2013.
Oversee.net continued to prosper, and Oak Hill gained control of the ODN board in 2009. In 2011, according to a legal complaint, the directors began pushing management to accumulate cash and a series of asset sales ensued, some at substantial losses. In 2013, Oak Hill exercised its redemption right and, unable to make the full payment, Oversee.net kept offloading pieces of the business. By 2015, it was a shell of its former self, with a mere $11 million in annual revenue.
Last year, Frederick Hsu, one of Oversee.net's founders, sued. He claimed the board had breached its duty to the common stockholders with fire sales designed merely to satisfy Oak Hill’s redemption rights. Oversee.net was left to limp along, he said, unable to generate long-term value for other investors.
Oak Hill asked the court to throw out the case, stressing that the asset sales and payments on the preferred stock had all been legal. But Laster, who again was presiding, refused. Elaborating on his Trados ruling, he agreed last month that Oversee.net was obligated to cash out the preferred shares, but also had a duty to consider whether it was in the best interests of the common shareholders to violate that obligation.
Even if such an “efficient breach” prompted liability for damages, he said, it might have left the otherwise thriving firm and its backers better off in the long run. What’s more, because Oak Hill controlled the ODN board, its behavior was subject to the strictest standard of review. The lawsuit would continue.
Even if Hsu ultimately wins, though, the victory for common stockholders more widely may be short-lived. The reason rests in the very nature of preferred stock.
As it's a hybrid of equity and contract, investors can bargain over the terms. A venture-capital firm could, for example, require a hefty increase in the rate at which a stock’s dividend accrues if the firm wasn’t sold or the preferred redeemed by a certain date. A big enough penalty would essentially force a startup to comply. An investor also could demand so-called drag-along rights, which allow a majority shareholder to force the minority to join a sale of the company – with minimal board involvement.
A third option would be to insist on preferred stock from a limited-liability company – or LLC – created, say, as a holding company for the operating firm. In Delaware, LLCs allow its members to strictly limit the duties that officers and directors owe to shareholders.
Clever lawyering can only go so far, however, before the rules catch up with possible abuses. Courts are, for example, in the early stages of scrutinizing LLCs. In any event, certain principles, including the need to police conflicts of interest, never go out of style. That may save startups from the abuses of redemption.