Exploring a Case of VC Breaching Duty of Loyalty and the Risks of Inside-Led Rounds

This chapter explores a case of a VC breaching their duty of loyalty and the consequences that followed. It also discusses the risks and complications of inside-led rounds and emphasizes the importance of a good process and understanding financing options.

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Episode notes

0:00 -- Intro.

1:27 -- About this podcast's sponsor: The American College of Governance Counsel.

2:23 -- Intro of Webinar (and speakers) by Nancy Easterbrook, Executive Director of SVDX.

5:33 -- Start of webinar by Dan Siciliano, Chair of SVDX.

6:40 -- Some differences between private (VC-backed) and public boards.

9:23 -- The role of independent directors in venture-backed companies.

14:00 -- Specific issues in VC industry: preferred vs common shares and impact on director fiduciary duties and dual-fiduciary duties. The Trados case (2013).

18:14 -- An edge-case proposed by Heidi Roizen: voting as a director vs voting as a shareholder. The "sanctity of the preference stack" vs management carve-out.

23:44 -- How "bad" directors can negatively impact companies and the proper use of special independent committees to "cleanse transactions." The role company counsel. Funding managing incentive plans (MIPs).

29:39 -- Two lessons for independent directors from Heidi Roizen: 1) "avoid messing with waterfall distributions" and 2) run a thorough process.

33:52 -- Important take-away from the Trados case: fiduciary duties are owed to the common stockholders.

40:00 -- The Basho case (2018), where a VC investor was ordered to pay ~$20m in damages for using contractual consent rights granted to it as a preferred shareholder together with “hardball” negotiating tactics to force the company to the brink of insolvency and leave it with no choice but to accept “oppressive” financing terms. Inside rounds vs outside rounds.

42:27 -- Other thoughts to encourage independent directors in venture-backed companies from Heidi Roizen. "You have to understand the payouts." "As a VC: lead, follow or get out of the way." "We can either be the crusher, or the crushee, but either way something is going to get crashed here." "Sometimes (...) the best thing you can do is say, look, I'll get out of the way.
You guys do what you want. We're in the risk business (...) almost half of our deals don't return the capital we put in. And so to be assholes about stuff is a bad idea. You may win the battle, but lose the war, right? You may, you know, twist somebody's arm and get your couple million back, but no entrepreneur is going to want to work with you anymore."

49:09 -- On director education for venture-backed companies. New program to launch from UC Law SF and Cooley in San Francisco in March 2024! *For more details: contact Evan Epstein at epsteinevan@uclawsf.edu.

51:03 -- Why there are so few independent directors in venture-backed companies? Heidi Roizen: "I think they're undervalued by both investors and entrepreneurs." On board education: Heidi recommends Brad Feld's books, including Venture Deals and Startup Boards. Book mentioned by Evan: Founder vs Investor (by Zalman and Neumann).

56:03 -- Heidi's recommendation for independent directors of companies running out of cash: "If the company you're on the board of has only a year or less of runway, you already should be speaking up. If your company has nine months or less of runway, you should already be beginning a process to be sold. And if your company has four months or less of runway, I would resign from that board as an independent. I would speak early, speak often, and if nobody's paying attention to you, I would actually get off that board." "[A]ll the problems happen when you have bad process and when you run out of money."

59:06 -- The enhanced role of the board in this downmarket. Heidi: "Structured deals are board for startups."

You can follow Evan on social media at:

Twitter: @evanepstein

LinkedIn: https://www.linkedin.com/in/epsteinevan/

Substack: https://evanepstein.substack.com/

You can follow Heidi on social media at:

Twitter: @HeidiRoizen

LinkedIn: https://www.linkedin.com/in/heidiroizen/

The Startup Solution: https://threshold.vc/podcast

Threshold VC: https://threshold.vc/

You can follow SVDX on social media at:

Twitter: @svdx1