The bubble may have burst, but many companies are still hanging on by their fingernails. Professional investors may want to cut their losses and turn their attention to new opportunities, but before they do, they should consider their obligations to the company.
- Fiduciary Duties to Other Shareholders. You may have fiduciary obligations to other shareholders. Ordinarily, representing the best interests of the company will protect you, but any decision regarding down-rounds and the like raise issues. Even actions you take on your own behalf may raise issues. For example, you may decide to write down your investment because you possess superior information. Given the current trend in requiring publication of fund performance, that decision may give rise to unexpected conflicts.
In order to protect yourself, you need to…make sure that your actions regarding the company’s securities are based on information that is public. If the information you possess is not yet public, consider asking the company to make it public. If this cannot be done, consider and seek legal advice on the advisability of erecting an ethical wall between you and the people who make decisions at your firm regarding the buying and selling of securities.
- Wash-Out Financing Transactions. Although generally directors have significant protection under the Business Judgment Rule for decisions made in good faith regarding the terms of new financings, there are limits on that protection, particularly where many, but not all, existing investors are participating. The Alantec case is an illustration of what not to do.
In order to protect yourself, you need to…make sure that the directors have been fully informed. This may require the hiring of outside professionals who can report to the directors and on whose advice the directors are entitled to rely. For example, a consultant’s analysis about the reasonableness of the terms of the new financings and the lack of any more attractive alternatives could be invaluable in thwarting any after-the-fact criticism. In addition, you may need the consent of a majority of nonparticipating shareholders, particularly if you are subject to California law.
- Fundamental Changes in Business Plan. It may become apparent at some point before all your money is spent that no one wants to buy pet food over the Web. You are then faced with the question of whether to liquidate and distribute that money out, or find a new business plan that will make profitable use of those funds.
In order to protect yourself, you need to…again, seek input from consultants upon whose advice the directors can rely. Consider the possibility of informing the stockholders of your conclusions and giving them a choice between getting a distribution now or letting it ride on the new course chosen for the company.
- Consider Fundamental Changes in Corporate Structure before a Fire Sale. If a company has good technology, but will not be able to market it profitably, you might consider selling the technology. However, most buyers will heavily discount the sales price, partly because they are taking lots of risk, but mostly because they can (since generally a company’s technology is sold only when all other alternatives have been exhausted). You should consider converting the company from an active business involving the development of technology into a passive licensing business. A license can provide the opportunity for upside without the ongoing costs associated with continued development of the technology and marketing. Even your tax-exempt investors can hold LLC interests if the LLC is only collecting royalties–and then you may be able to get a better price for the technology because (1) the licensee isn’t taking as much risk; and (2) you will have decided to make the change before you have exhausted all other alternatives.
In order to protect yourself, you need to…consider alternatives as early as possible and don’t delay until the company is out of cash, creditors are hounding it, and the only way out is bankruptcy.
- Wind Up the Business. One question here is timing–do you decide to wind up before all cash is gone? Or do you keep trying to succeed until you have no other alternatives? Generally, insiders will have no incentive to throw in the towel until the last dollar (and then some) is spent. In that event, not only will there be no value to distribute to the shareholders, but the trade creditors and lenders to the company will likely receive less than they are due. You will have to balance your relationship with those vendors with what’s best for the company and its shareholders, and will have to pay attention to whether certain vendors are receiving preferential treatment because they are more insistent regarding collections, or they hold a deposit (e.g., a retainer held by the lawyers).
In order to protect yourself, you need to…retain competent legal and financial (turnaround) advisors early in the process. Some courts have found that as a company approaches the “zone of insolvency,” the directors owe a duty to creditors as well as to stockholders. Allowing money to be spent that might have otherwise been used to pay creditor claims could lead to a lawsuit where creditors claim the company was mismanaged. To gain protection under the Business Judgment Rule, directors must make informed decisions in good faith and in doing so are entitled to rely on advice from consultants.
- Decision to Merge with Another Company (particularly one in which you also invest) . If you decide to sell the company or to merge it into another, you will have all the valuation issues discussed below under "Distributions," plus others. What kind of indemnity do old shareholders give, how are the related liabilities allocated among claimants (e.g., common first)? And how do you justify value if you also hold an investment in the acquiring company?
In order to protect yourself, you need to…separate yourself from the decision making if you have a financial interest in the merger candidate. You have a duty of loyalty to the company and it is difficult if not impossible to manage that duty while also doing the best job you can for the other investment. In addition, consider getting a fairness opinion from an independent consultant. While it can cost a lot, don’t be “penny wise but pound foolish.”
- Timing of Tax Losses. If it is decided that the company should be wound up (either simply liquidated or converted into a licensing company), its shareholders will want to maximize the value of their tax losses (which generally means using them as soon as possible). Often, at year end, the dissolution of the company will not quite be complete, and the board will have to decide whether to take measures to crystallize a loss (e.g., by merging into an LLC and effecting a liquidation for tax purposes), or whether to minimize costs and simply let the tax loss occur whenever everything is done.
In order to protect yourself, you need to…get the process started as soon as possible and make sure the others on your team understand the realities of when things need to get done and why. Establish a track record for moving the process forward as quickly as reasonably possible. Then, if a decision has to be made, get advice from consultants so that you can establish your entitlement to the Business Judgment Rule.
- Employment Taxes. Any person who has the ability to disburse funds on behalf of the company can be liable personally for unpaid payroll or withholding taxes. Ordinarily, this risk can be minimized by making sure that the company actually withholds and pays these amounts to the government. However, where an employee has borrowed money from the company to exercise his/her stock options, you will need to be extra careful. The cancellation of those debts (which is likely to occur as insolvency approaches) will result in compensation income with no source from which the company can withhold. Fortunately, Sarbanes-Oxley has virtually eliminated employee debt.
In order to protect yourself, you need to…set up and fund special bank accounts for wages and taxes. Make sure the special purpose of the account is known to the bank and is reflected in the account name. Do not use the account for any other purpose beyond that for which it was intended. Also, make sure that any consensual debt forgiveness includes a partial payment sufficient to cover withholding taxes. Alternatively, leave the debt outstanding (and the employee at risk of the bankruptcy court trustee), so that the company can argue the forgiveness was not compensatory, but was the result of a decision that the debt is not worth collecting.
- Distributions. Directors who approve a distribution to stockholders are personally liable for the return of those distributions if paid by a company in violation of law. Most states make it illegal to distribute money to stockholders if the distribution will render the company insolvent. A corollary of this principle is that allocating a liquidating distribution among shareholders can be equally tricky. If there is any possibility that the value of the distribution was not properly determined (i.e., the distribution was property, such as patents and copyrights, rather than cash), some shareholders may file suit.
In order to protect yourself, you need to…make sure every distribution to stockholders is preceded by a valuation of the company by an independent consultant.
- Resignation from the Board. Query whether it is better to resign from all positions with the company and so avoid being blamed for decisions made after you resign, or to stay with the company and prevent it from taking actions that will encourage litigation regarding historic decisions.
In order to protect yourself, you need to…resign as soon as you are unable to make decisions on behalf of the company without regard to the impact on your investment. If you cannot be loyal to the company, you have no business on the board. There are even a few cases out there that hold that the last director cannot resign and that it may be actionable for a director to resign if he/she knows that doing so will put the company in the hands of other directors who will not protect the interests of those entitled to protection. As a result, it is sometimes better to resign early rather than late.
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.