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Control Issues Generally In Term Sheets

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP



To understand that cohort of issues which has to do with the control of a start-up, some background is in order. Thus, in a mature business corporation, it has been understood, at least since Berle and Means's seminal work, [1] that nonmanagement purchasers of stock in public companies are passive investors. If they don't like the way the company is being run, their remedy (absent some actionable legal wrong) is to sell their shares. Venture capital operates on an entirely different set of principles. When raising money from his own investors—the limited partners in his venture pool—the professional manager of a venture capital partnership holds himself out as someone with the expertise to "add value" to the investments under his control. The notion is that the typical founder is an incomplete businessman, with gaps in experience in matters such as financial management and marketing. An active board of directors, staffed by representatives of the investors, is expected to help fill these gaps. Significantly, even in successful venture-backed companies, a large percentage of the founders are fired, retired, or otherwise relieved of their duties prior to the company's achieving its maturity. It is rare to find executives with the necessary breadth and scope to take the company through every phase of its path toward maturity. Consequently, a term sheet will deal with a series of related control issues immediately after the question of valuation is tentatively settled.

Board Seats

A business corporation is, as a legal matter, run by its board of directors. [2] In point of fact, many boards elect to yield the operational management of the company's affairs to a single individual, the chief executive officer, but the residual legal responsibility is not delegable. The board remains responsible. The president is a member of the board (under the laws of some states he has to be), and certain powers are delegated to him formally, usually in the bylaws. But the president's authority is derivative; to restate this important point, a seat on the board carries with it legal power and responsibility, whether the occupant likes it or not. In negotiating the term sheet, the struggle for power concerns who sits on the board.

That question breaks down into subissues. If the investors hold a majority of the stock but elect to retain fewer than 51 percent of the seats, when is it appropriate for the investors, assuming that they agree together as a group, to take over control? Regardless of who holds a majority of the outstanding shares, should the founder and his management colleagues retain control of the board until something objectively goes wrong, such as a failure to meet revenue benchmarks for X quarters, for example? The term sheet often unbundles the macro-question of control and allocates the parts separately, across a spectrum of issues and across a period of time. Thus, it may provide that the investors may retain control over certain core questions—management compensation, for example—and not others. Further, the term sheet may provide for a control "flip," meaning that the investors are content with a minority of the board as long as everything is going well; they succeed to outright control of the board when and as the company gets in trouble, allowing them to tie a can to the founder. Control flip can occur when benchmarks are not met or for more serious reasons, such as the violation of negative covenants in a Stock Purchase Agreement.

From the investors' standpoint, control is a two-edged sword, since control entails some quantum of legal responsibility. Venture capital investment is risky enough if all that has been put at risk are the dollars invested in the enterprise. If, in addition, an investor can be held liable to the creditors, and, indeed, to other investors, in an insolvent enterprise, his risk parameters are undoubtedly exceeded. Further, whether or not the liability is imposed by reason of the exercise of controlling influence, any board member has an assortment of "fiduciary" duties, [3] a phrase that, once appearing in a judicial opinion, usually takes on a precise legal meaning, that is, recovery by the plaintiff. [4]

Apart from a few isolated decisions or special fact situations generally involving lenders, [5] it has as yet not been popular to impose liability, beyond the investment made, on investors who are deemed to be in control of a failed corporation unless they do something to impact directly on the minority, such as squeezing them out of the enterprise or feathering their own nests. Indeed, if such were to eventuate through the agency of activist judges making new law in line with their underdog sympathies, it would be a formidable problem for the venture capital industry generally. However, it is an issue that cannot be ignored, particularly in view of the fact that directors and officers' liability policies are almost never affordable at the start-up stage (if, indeed, affordable at all). [6]

Various provisions can be reflected in the term sheet to deal with the problem. First, some careful investors prefer to bargain for visitation or attendance rights for their representative on the board of directors, meaning the right to attend board meetings but not to vote. Occasionally, these rights are memorialized by calling the investor representative "honorary" or "advisory" directors. These measures should be viewed in context. The real power the investor group has over a cash- poor corporation is economic, not legal; the investors are the only source of fresh funds to keep the doors open. No law requires an investor group to advance fresh money [7] (absent an agreement or except at the conclusion of a lawsuit holding it liable in damages for some form of misconduct), so the power of the purse rests with the investors. As it is sometimes phrased, the Golden Rule obtains: "He who has the gold makes the rules." The bulk of the cases to date have involved variations on the theme of the doctrine of equitable subordination, [8] whereby senior investors, those holding a debt security of some sort, have seen their priority vanish in an insolvency proceeding. The notion is that, if the creditors take control of an insolvent company and manage its affairs so as to favor themselves, it is somehow inequitable to allow them to retain their status as creditors. Because of the heavy debt structure of leveraged buyouts, the doctrine of equitable subordination is much discussed in that arena. In start-ups, where the investors are not as prone to invest in debt securities, the doctrine is less intimidating.


[1] Berle & Means, The Modern Corporation and Private Property (1932). This atmosphere may be changing as large pension plans, feeling they may be locked in because their positions are so gigantic, maneuver to influence the boards of their portfolio companies.

[2] Del. Code Ann. tit. 8, § 141(a) (1983 & Supp. 1986).

[3] See Knauss, Corporate Governance—A Moving Target, 79 Mich. L. Rev. 478, 487 (1981).

[4] Bartlett, The Law Business: A Tired Monopoly 138 (1982).

[5] One of the most intimidating opinions, albeit from a court without particular distinction, is State Nat'l Bank of El Paso v. Farah Mfg. Co., Inc., 678 S.W.2d 661 (Tex. Ct. App. 1984). In that case, the lender assumed control of the debtor through a "management clause," installed its own people, and wound up liable for damages in excess of $18 million for, among other things, "duress." See generally Bartlett & Lapatin, The Status of a Creditor as a "Controlling Person," 28 Mercer L. Rev. 639 (1977).

[6] According to a National Venture Capital Association survey, the difficulty in obtaining affordable D&O insurance has reached "crisis proportions." Venture Cap. J., May 1987, at 2. See generally Knepper, Officers and Directors: Indemnification and Liability Insurance—An Update, 30 Bus. Law. 951 (Apn 1975).

[7] Some cases come close. See KMC Co., Inc. v. Irving Trust Co., 757 F.2d 752 (6th Cir. 1985) (the creditor bank was held liable for failing to advance funds under an agreement providing for discretionary lending up to a certain amount.) See the discussion of the case in Davis, Emerging Theories of Lender Liability 39 (1985).

[8] The court in Wright v. Heizer Corp., 560 F.2d 236 (7th Cir. 1977), in an unhappily worded opinion, extended the doctrine of equitable subordination in a venture capital context to limits which, if pursued in subsequent decisions, may prove intimidating to investors. See the discussion of the case in Bartlett, The Law Business: A Tired Monopoly 138 (1982).

Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com

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