when absolutely nothing is entirely fair: m&a … · when absolutely nothing is entirely fair:...

When Absolutely Nothing is Entirely Fair: M&A Lessons from In re Trados

Speakers:

Thomas Mullen, Potter, Anderson, Corroon LLP Gary Hammersmith, McElroy, Deutsch, Mulvaney, & Carpenter, LLP

COMMITTEE SPONSOR: Private Equity and Venture Capital Chair: Jonathan Gworek

When Absolutely Nothing is Entirely Fair: M&A Lessons from In re Trados

October 4, 2013

Thomas A. Mullen 302-984-6204 [email protected]

3

Background of In re Trados Trados Inc. was a privately held Delaware corporation

engaged in the production of desktop and enterprise translation software. Beginning in 2000, Trados obtained several rounds of

venture capital financing. – The VC firms controlled a majority of stockholder voting power (but

there was no single controlling stockholder or control group). – The preferred stock had typical terms, including “deemed

liquidation” preferences, cumulative dividends, voting with common on an as-converted basis, and other customary protective provisions.

– The VC firms were entitled to designate directors constituting a majority of the board.

– The VC firms did not have a contractual right to force the sale of the company.

4

Composition of the seven member Trados board. – Three directors were principles of the VC firms that nominated

them. – Two directors were members of Trados management. – One was nominated by a VC firm as an “outside” director, was not

a principle of the VC firm, but had business relationships with the VC firm.

– One was nominated by a VC firm as an “outside” director and was not affiliated with the VC firm.

Background of In re Trados (cont.)

5

The Company is positioned for a sale. – Trados experienced revenue growth but was not profitable, and by

2004, the VCs were looking to sell the company.

– Trados retained an investment bank, JMP Securities, to explore a potential sale. JMP gave a presentation valuing Trados at between $55–$75 million. JMP identified 28 potential acquirers, most of which had no interest

– In June 2004, SDL plc, a publicly traded software company, expressed interest in purchasing Trados.

– On July 26, 2004, SDL offered $40 million for Trados, consisting of $10 million in cash and $30 million in stock.

– The Trados board rejected the offer and hired a new CEO to improve the company’s financial condition and to position the company for a sale.


6

The Board adopts a Management Incentive Plan (“MIP”).

– In 2004, the VC board representatives determined to incentivize senior management to remain with the company during the sale process.

– The board unanimously adopted the MIP, which compensated senior management with a portion of any sale proceeds, based on an escalating percentage depending on the value achieved.

– The MIP benefits were payable even if the transaction yielded nothing for the common stock.

– The MIP also contained a “cut-back” feature providing that, to the extent MIP participants also received consideration as equity holders, their MIP payout would be reduced by the amount of the consideration received.


7

Trados is sold for $60 million. – In February 2005, SDL agreed to acquire Trados for $60 million

($50 million in cash and $10 million in SDL stock).

– In June 2005, the Trados board and stockholders each approved the sale, which closed on July 7, 2005.

– Under the MIP, the first $7.8 million of the sale proceeds went to Trados management.

– The remaining $52.2 million was paid to the preferred stockholders in partial satisfaction of the liquidation preference (with approximately $4 million held back in an indemnification escrow). The preferred stock’s liquidation preference was $57.9 million.

– The common stockholders received nothing.


8

A stockholder owning about 5% of Trados’ common stock petitioned for appraisal of his common shares under DGCL § 262.

Three years later, based on discovery obtained in the appraisal action, the stockholder filed a class action lawsuit on behalf of common stockholders alleging that the Trados directors breached their duty of loyalty by favoring the interests of the preferred stockholders at the expense of the common stockholders with respect to the Merger.

In 2009, former Chancellor Chandler denied defendants’ motion to dismiss, holding that plaintiff had stated a claim with respect to all but one claim. See In re Trados Inc. S’holder Litig., 2009 WL 2225958 (Del. Ch. July 24, 2009).

The Court explained that the factual allegations in the Complaint supported a reasonable inference that the interests of the preferred and common stockholders diverged with respect to the decision to enter into a transaction that triggered the liquidation preference of the preferred and resulted in no consideration to the common stockholders.

The ruling troubled the VC community because it called into question whether their contractual preferences would be respected when the company is sold for less than the aggregate liquidation preference (and the common stockholders receive nothing).

Delaware Chancery Court’s Prior 2009 Ruling

9

Vice Chancellor Laster issued the Court’s post-trial opinion on August 16, 2013. The Court held: – Entire Fairness Standard applied. – Defendants proved that the Merger was fair.

• The sales process was not fair. • But the price was fair.

– The appraised value of the common stock was zero. – Plaintiff was granted leave to make a formal application for

attorneys fees.

The Trados Post-Trial Opinion

10

Entire Fairness applied because six of the seven Trados directors were materially conflicted. – Two management directors received material personal benefits from the

Merger, including $2.34 million and $1 million, respectively, from the MIP, as well as employment with SDL following the Merger.

– The three principles of their nominating VC firms were conflicted due to their status as “dual fiduciaries.”

– The conflict resulted from the divergence of interests of the common and preferred stock given that the liquidation preference affected the choice between (i) selling the company and (ii) maintaining the company as an independent private business. The common could expect little or no value from an immediate sale and thus would prefer to take the chance on growing the business and achieving value for the common. The VC firms preferred an immediate sale, given the risks involved in continuing the business, the limited up-side that the non-participating preferred stock would receive from the potential increase in the company’s value over time, and the VC firms’ institutional desire to cut its losses and focus on other opportunities.

– One of the remaining directors nominated by a VC firm was not disinterested and independent because of, among other things, his relationships and business dealings with the VC firm, which resulted in a sense of “owingness” that compromised his independence.

The Trados Post-Trial Opinion (cont.)

11

Defendants did not prove fair dealing. – The Trados directors “did not understand that their job was to

maximize the value of the corporation for the benefit of the common stockholders, and they refused to recognize the conflicts they faced.”

– The directors did not consider the interests of the common stock. – “There was never any effort to explore prices above $60 million or to

consider whether alternatives to the Merger might generate value for the common.”

– The board did not form a special committee (there was one director that arguably qualified to serve on a special committee).

– The board did not obtain a fairness opinion (“They also chose not to obtain a fairness opinion to analyze the Merger or evaluate other possibilities from the perspective of the common stockholders”).

– The board did not condition the Merger on approval of a “majority of the minority” or “majority of the common” (“Finally, fair dealing encompasses questions of how stockholder approval was obtained. The defendants never considered conditioning the Merger on the vote of a majority of disinterested common stockholders”).


12

Defendants did not prove fair dealing (cont.). – The Court also found that the directors adopted the MIP to incent

management to favor a quick exit, and that the MIP “took value away from the common” in that, “without the MIP, the preferred stockholders would have received $57.9 million and the common stockholders $2.1 million.”

– The Court stated: “As a result, the common stockholders contributed 100% of their ex-MIP proceeds while the preferred stockholders only contributed 10% ($5.7 million / $57.9 million).”

– According to the Court, “the MIP skewed the negotiation and structure of the Merger in a manner adverse to the common stockholders.”

– The MIP cutback feature also “eliminated any financial incentive for senior management to push for a price at which the common stock would receive value or to favor remaining independent with the prospect of a higher valued sale at a later date.”


13

But the Defendants satisfied the fair price test. – The Court found the Merger price ($0) for the common stock was fair

because the common stock had “no economic value before the Merger and the common stockholders received in the Merger the substantial equivalent in value of what they had before.”

– The Court found credible the testimony of the defense expert, who, using a DCF analysis and plaintiff-friendly assumptions, valued Trados at $51.9 million, which was less than the Merger price.

– The Court concluded “that Trados would not be able to grow at a rate that would yield value for the common. Trados likely could self-fund, avoid bankruptcy, and continue operating, but it did not have a realistic chance of generating sufficient return to escape the gravitational pull of the large liquidation preference and cumulative dividend” held by the preferred stockholders.

Thus, the Court determined that the Merger was entirely fair and, accordingly, the Court held that the defendants did not breach their fiduciary duties.


14

The Trados common stock was appraised at zero. – The Court explained that the determination that no breach of duty

occurred because the Merger price was fair “does not necessarily moot the companion appraisal proceeding.”

– “A court could conclude that a price fell within the range of fairness and could not support fiduciary liability, yet still find that the point calculation demanded by the appraisal statute yields an award in excess of the merger price.”

– But here, “[i]f Trados continued to operate as a stand-alone entity, then the common stock had no economic value, whether for purposes of an entire fairness case or an appraisal proceeding.”

– As with the fair price determination, “Trados had no realistic chance of growing fast enough to overcome the preferred stock’s existing liquidation preference and the 8% cumulative dividend.”


15

The Court granted plaintiff leave to make a formal application for attorneys’ fees. – Fees may be shifted here based on “serial failures to produce

documents.”

– Defendants’ motion for summary judgment on appraisal which “could be regarded as frivolous.”

– “The directors’ frequently less-than-credible trial testimony and their changes of position between deposition and trial.”


16

VC firms should consider ex ante planning of contractual exit rights that place decision making in the hands of the investors, rather than the board. – The Court noted that the VC firms did not have contractual rights to

force a sale that could have been negotiated at the time of investment, and suggested that it could be possible to circumvent the heightened standard of review through contractual drag along rights or charter provisions that may be exercised by the preferred stockholders without the involvement of the board.

– NVCA forms response to the 2009 Trados decision.

– Practical and legal limitations on contractual exit rights.

– Choice of business entity – consider using Delaware LLC. • The DE LLC Act permits modification and elimination of fiduciary duties,

including providing that directors owe duties only to their nominating investor, and permits management by members, including allowing certain members to control sale process or similar material transactions.

Lessons From In re Trados

17

Parties should recognize the potential conflicts of VC firms’ principals and affiliates serving as directors resulting from the divergence of interests between common stock and preferred stock. – Directors owe fiduciary duties to the corporation and the common

stockholders.

– VC principals have “dual allegiances” – to the common (in their capacity as directors) and to their VC firm that holds preferred (in their capacity as principals or affiliates of the VC firm).

– VC principals serving on the board of a portfolio company need to be aware of the potential for conflicts to arise based on divergence of interests at any time.

– The resulting conflict may trigger Entire Fairness review where the VC nominees constitute a majority of the board (or together with other conflicted directors, such as members of management).

Lessons From In re Trados (cont.)

18

An outside director that is routinely nominated by a VC firm to serve as may not be independent. – The Trados decision highlights the relevance of business contacts and

relationships between VC firms and VC sourced “outside” directors.

– A Delaware court will closely review the nature of such relationships, and while service on a limited number of boards as a nominee of a particular VC firm by itself should not cause a director to be beholden to the nominating VC firm, additional relationships may tip the scale in favor of a finding of a lack of independence.

– The Trados court also noted the web of interrelationships that characterizes the Silicon Valley startup community that may call into question the independence of “outside” directors on venture capital-backed startup boards.

– A board needs to consider carefully whether so-called independent directors may be viewed as beholden to the nominating VC firms by virtue of their previous business relationships, affiliations and contacts.


19

The Trados analysis arguably applies even where common stockholders receive some consideration in sales transaction. – The Trados court’s basis for finding a divergence of interests which

implicated the entire fairness standard did not depend on zero consideration for the common stockholders.

– The Court focused on the timing of a sale and on the VC firms’ interest in avoiding “sideways situations” and selling off “zombie” investments.

– The “distorting effects” of theconflict over whether to sell or to maintain the company as a stand-alone business most likely arise in “intermediate cases” were the investment is not a stunning success (everybody wins) or a complete failure (everybody loses). These “intermediate cases” may involve situations where there is some present value in the common equity – but not enough to compel the VC investors to continue the business.


20

Fair price may predominate over fair dealing under the entire fairness standard. – The Trados opinion indicates that directors may fail the fair process

prong of entire fairness, but still satisfy entire fairness by proving that the price was fair. Whether this approach to entire fairness will be adopted by the Delaware Supreme Court or with other members of the Chancery Court remains to be seen.

– A board of a VC-backed corporation that is disinclined to use fairness procedures such as a special committee and majority-of-the-minority stockholder approval should weigh the costs and benefits of those procedures against the likelihood, as well as the cost and commitment of time and effort to defending, a stockholder lawsuit.

– The Trados court’s decision to find no breach of fiduciary duty (rather than to find a breach and award no money damages because the common stockholders had no economic value) impacts defendant directors’ indemnification rights and access to D&O coverage. A board should keep those risks in mind when deciding whether to use fairness procedures and to otherwise attempt to avoid fairness claims.


21

The board of a VC-backed corporation must consider the interests of the common stockholders when considering a change of control transaction. – The directors fiduciary duties run to the corporation and the

common stockholders.

– The board should carefully and clearly document its consideration of the interests of common stockholders, particularly when those interests potentially diverge from those of preferred stockholders.

– Procedural protections such as a special committee, fairness opinion, and majority-of-the-minority voting conditions are not required, but should be considered.

– The use of a special committee or majority-of-the-minority vote can have the powerful effect of shifting the standard of review from entire fairness to business judgment rule (so long as there is no conflicted controlling stockholder).


22

The adoption of Management Incentive Plans may be subject to fiduciary challenge. – The board should consider the impact of a MIP on the incentives of

management. – The board should consider the funding allocation of the plan, and

whether it fairly allocates the costs between the common and the preferred stock.

– The terms of the MIP in this case (including the funding allocation and the cut-back feature) were evidence of an unfair process. The board also failed to consider the impact of an MIP on common stockholders.

– In Trados, the Court pointed out that the plaintiff was not challenging the adoption of the MIP but also noted that the MIP was approved by conflicted directors and its adoption could have been independently challenged under the entire fairness standard.


23

Q&A

when absolutely nothing is entirely fair: m&a … · when absolutely nothing is entirely fair:...

Documents