Early stage companies are typically urged, and appropriately so, to ensure that their “charter documents,” specifically their certificate of incorporation and bylaws, are consistent with statutory requirements in their jurisdiction of organization, and reflect the short term and identifiable long-term objectives of the founding shareholders.  Many founders will search for “boilerplate” documents on the internet or other public sources, and as their enterprises grow, seek to modify those forms to cover such items as super-majority voting provisions, director removal provisions, etc.  Issues may arise, however, where those modifications are not consistent with statutory requirements.

For example, the Delaware Court of Chancery recently held in Frechter v. Zier, C.A. No. 12038-VCG, that a bylaw provision requiring supermajority stockholder approval for the removal of a director was inconsistent with Section 141(k) of Delaware’s General Corporation Law.  Section 141(k) provides that (other than in cases of staggered boards or cumulative voting) a director may be removed with or without cause by a majority of the voting stockholders.  While some provisions of the DGCL are based on a default rule that applies “unless otherwise provided in the certificate of incorporation or bylaws” the Court of Chancery held the majority standard set forth in Section 141(k) could not be modified by a bylaw provision.

The lesson taught by this decision is that it should not be assumed that statutory requirements may always be modified by inclusion of a contrary provision in a corporation’s certificate of incorporation or bylaws.  The starting point should always be a clear understanding of the statutory requirement.  The next step in the analysis is whether the statutory requirement is subject to modification within a corporation’s charter documents, and, if so, where that modification must be set forth in order to be enforceable.  In making this analysis, the different processes for how a corporation’s certificate of incorporation may be amended as compared to an amendment to a corporation’s bylaws must be considered.  In this regard, it should be noted that Section 102(b)(4) of the DGCL allows a corporation to include a provision in its certificate of incorporation that requires a supermajority vote for any corporate action.

Early stage companies, when drafting and amending their charter documents and considering such issues as general voting provisions, director removal, approval of corporate actions such as mergers, asset sales and dissolutions, should give appropriate thought to how the applicable statutory provisions require those issues to be addressed. Doing so will avoid statutory challenges to the validity of those actions in the future.

Canada and investing
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Canada has seen some recent success in having its venture-backed companies progress through IPO, and total venture capital invested in Canadian companies has doubled over the past 5 years.  As U.S.-based investors look across the border for investment opportunities involving Canadian technology companies, they should be aware of some key differences between U.S. and Canadian laws that impact the way deals are structured in Canada.  Here is a quick summary of some of the important items to consider:

  • Canadian securities laws are set at the provincial, as opposed to the federal, level. Canada is working towards a national securities law framework, but for now Canadian companies have to consider the laws of their particular province.  From a practical point of view, this is much less likely to impact private companies than companies entering the public markets.
  • Canadian corporate law allows a company to have unlimited authorized capital, and most Canadian companies take advantage of this opportunity. Obviously, this raises dilution concerns which are usually addressed by including protective provisions in a company’s charter documents or an investor rights type agreement which imposes a predetermined level of shareholder approval before additional shares may be issued.
  • Canadian companies can issue preferred shares in series, as seen in the US. However, in Canada, no series of shares can have a priority over any other series within the same class of shares with respect to dividends or return of capital.  Consequently, Canadian companies will typically issue multiple classes of preferred shares, rather than multiple series within a single class of shares, in order to allow for differing liquidation preferences among different investment rounds.
  • Investors should review any possible conflicts between Canadian statutory voting rights, which provide for separate class voting rights in connection with certain extraordinary corporate events, and negotiated approval rights. Similarly, Canadian law is not as flexible as, for example, Delaware law in the area of shareholder consents.  In Canada, shareholder consent must be obtained either at a duly called shareholder meeting or by way of a unanimous written consent (although this does not apply as to matters that require shareholder consent as a result of contractual approval rights).  Considering that at some point a unanimous written consent of shareholders may be a logistical nightmare, voting trusts are sometime used, or powers of attorney are granted by investors.
  • Unanimous shareholder agreements are an interesting creature of Canadian law. This is an agreement among all of the shareholders of a company that, although a contract, is considered as one of the company’s organizational documents, alongside the company’s articles and bylaws.  As such, they are considered binding on all future shareholders, even if they do not sign the agreement.  Also, they allow shareholders to impose limits on the authority of the company’s directors to manage the business of the company, so that the shareholders may bypass the board and manage the company directly.  These agreements are widely used by Canadian private companies, and frequently also cover, in a single document, many of the governance, voting and shareholder rights that U.S.-based transactions may address in multiple agreements, such as investor rights, voting and registration rights agreements.
  • Board nomination rights are also typically found in a unanimous shareholder agreement as opposed to the articles of incorporation. In this regard, it is important to note that some Canadian companies, depending upon their province of organization, may require that at least 25 percent of the company’s directors be Canadian residents, and that, in order for a valid meeting of the directors of the company to be held, at least 25 percent of the directors present must be Canadian residents.  U.S.-based investors who wish to ensure that they can place non-Canadian residents on the board of directors should negotiate for these rights in the context of the composition of the non-Canadian members of the board.

Certainly this is not an exhaustive list of issues to be considered in a cross-border investment transaction.  However, it is important for U.S. investors to understand and be prepared to address these significant differences between U.S. and Canadian deal structure when developing and implementing investment strategies.

Copyright: kentoh / 123RF Stock Photo
Copyright: kentoh / 123RF Stock Photo

“Healthcare IT” is a hot segment of the early stage investment market, both for entrepreneurial companies operating in this space and for private equity, venture capital and angel investors seeking to fund these types of companies.  Issues confronted by healthcare IT companies searching for capital, as well as their potential investors, extend beyond the “usual” evaluation of strengths, weaknesses, competition, scalability, etc., and include a specific focus on IT platform security and privacy safeguards.  Consequently, while all of the more typical due diligence questions are being asked by the investor and its legal counsel, target companies and their potential investors should also be focused on questions such as the following:

  • What is the existing state of the regulatory environment governing healthcare IT companies and does the target company exhibit a thorough understanding of this environment?
  • Are “best practices” privacy and security protocols being used by the target company?
  • Are ownership rights in the underlying data used by the target company properly addressed and adequately documented?
  • What is the target company’s level of exposure to claims from customer, supplier and/or subcontractor claims?

A healthcare IT company should be aware of the issues raised in these questions as early as possible in its life cycle, and should, at a minimum, address them as a centerpiece of its product development process.  From the investor’s perspective, devoting adequate time and resources to these issues during the due diligence process will allow it to properly identify potential risks prior to making its investment.  These concerted efforts will help both sides ensure the greatest possibility of a mutually advantageous investment transaction.

Early stage companies with valuable intellectual property often receive solicited or unsolicited opportunities to sell their business, which a buyer may view as a means of acquiring intellectual property.  Differences as to enterprise valuation may be bridged through an “earnout” mechanism whereby the buyer pays an initial amount at closing and, if certain milestones are met post-closing, an additional amount.

Sellers resist earnouts because, following closing, strategic issues that relate directly to the profitability of the business, which in turn directly affect whether an earnout will be paid to the seller, are to be decided by the buyer. As a result, sellers may seek to impose approval rights relating to the buyer’s conduct of the business post-closing.  Buyers will often resist this on the basis of “we bought it, we own it, we run it.”

The end result is often the inclusion of language in the acquisition documentation similar to the language at issue in Lazard Technology Partners, LLC v. Qinetiq North America Operations LLC, where the buyer was prohibited from “tak[ing] any action to divert or defer [revenue] with the intent of reducing or limiting the Earn-out Payment.”  There, when an earnout payment was not forthcoming, the seller sued arguing the buyer had breached its contractual obligations and had violated the implied covenant of good faith and fair dealing which is considered to underlie every commercial transaction.

The Delaware Court of Chancery held for the buyer, finding that the seller had not proven that the buyer had intended to limit the earnout, and that, notwithstanding that the buyer’s actions may have impacted the likelihood of an earnout, the court could not conclude that the buyer intended to reduce or limit the earnout.  The court also found the implied covenant of good faith and fair dealing was not applicable because there was no “gap to be filled” in the heavily negotiated acquisition agreement, which spoke for itself as to the buyer’s obligations.

The Delaware Supreme Court affirmed the Court of Chancery, suggesting that the implied covenant of good faith and fair dealing could exist side by side with a contractual covenant, but ultimately holding “the implied covenant did not prohibit the buyer’s conduct unless the buyer acted with the intent to deprive the seller of an earn-out payment.”

Sellers negotiating earnout arrangements should therefore not rely upon the implied covenant of good faith and fair dealing when the definitive agreement establishes a standard to be applied to the buyer’s post-closing actions.  On the other hand, Buyers should disclaim any implied duty of good faith and fair dealing so as to avoid application of an objective standard that may expand the contractual standard of behavior negotiated by the parties in the acquisition agreement.  This will help to retain focus on the buyer’s intent and will help to limit or eliminate an examination of the ultimate result of any decision by the buyer that conceivably impacts its obligation to make an earnout payment to the seller.

 

Investment
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Investors typically do not finance an early stage or middle market company with the intent to ultimately call for a redemption of the preferred shares that it receives from the company in connection with the original financing.  Such a situation signals a failed investment, as the return of the original purchase price for the investor’s preferred shares represents zero appreciation on the original investment.  However, there are circumstances where redemption is appropriate as a last option.

A recent Delaware Chancery Court decision in TCV v. TradingScreen provided some insights into Delaware’s approach to determining the circumstances under which a corporation is legally permitted to fulfill a demand for redemption, meshing the statutory concept of “surplus”, as such term is used in the Delaware General Corporation Law, and the common law concept of “funds legally available.”  The Delaware courts had previously left unanswered the question of whether the statutory standard of “surplus” was somehow different than the common law standard of “funds legally available.”  According to the Chancery Court in TCV v. TradingScreen, there is a difference.  While a calculation of “surplus” basically consists of net assets in excess of capital, “funds legally available” is to be determined on the basis of a “going concern/insolvency” analysis (i.e., would the company’s payment of the redemption amount to the investor impair the company’s ability to continue as a going concern and pay its debts when due?).  The risk to investors is that the viability of a contractual redemption right with respect to its preferred shares may be closely tied to the timing of the demand for redemption of those shares.

Final word on the matter will be provided by the Delaware Supreme Court, as the Chancery Court decision in TCV v. TradingScreen has been appealed.  In the meantime, companies and investors should be cognizant of the implications of the Chancery Court’s decision when negotiating the terms of a redemption provision and the remedies available to the preferred stockholders if the company is not able to satisfy a mandatory right of redemption.

Letters of intent (LOIs), term sheets, memoranda of understanding—any of these largely interchangeable documents can come into play when an early stage enterprise seeks capital to fund its growth or pursues other commercial transactions. Typically, these documents will be “non-binding” (meaning that their terms will not be legally enforceable by the parties and are merely expressions of the parties’ preliminary intent), but they can and often do include certain provisions that are expressly identified as legally binding on the parties, such as confidentiality and exclusivity provisions. All other provisions, including the business terms of the transaction and whether the transaction even occurs, are typically identified as non-binding.

While the concepts of binding and non-binding seem clear, the reality is that LOIs, especially when supplemented with definitive transaction documents, may contain ambiguities that can lead to disputes or even litigation over exactly which provisions are binding and non-binding. For example, in the Delaware Supreme Court case EV3 Inc. v. Lesh, a dispute arose between two parties who signed a non-binding LOI relating to the merger of one party into another. The final merger agreement signed by the parties provided for the bulk of the consideration payable to shareholders of the target company (Appriva Medical, Inc.) to be contingent upon the timely accomplishment of specified milestones relating to the approval and marketability of a medical device being developed by Appriva. When those milestones were not reached and the contingent payments to the shareholders of Appriva were not made by ev3, Inc., the Appriva shareholders sued ev3 claiming that it had breached a provision of the LOI which stated that ev3 “will commit to funding based on the projections prepared by its management to ensure that there is sufficient capital to achieve the performance milestones.” While this provision was in the non-binding LOI, it did not find its way into the final merger agreement. Instead, the merger agreement provided that ev3 would fund and pursue the regulatory milestones in its “sole discretion, to be exercised in good faith.”

The Delaware Supreme Court held that, notwithstanding an “integration clause” in the merger agreement providing that the LOI was not to be superseded by the merger agreement, only the binding provisions of the LOI (confidentiality, exclusivity, etc.) could be enforced. The Court reasoned that a conclusion finding that the non-binding provisions of the LOI somehow became binding because the LOI was not wholly superseded by the definitive terms of the merger agreement “would set a precedent that would undermine parties’ ability to negotiate and shape commercial agreements.”

Your lawyer can help you craft the appropriate language, but here is a sample of unambiguous language that should appear in an LOI:

“Except with regard to the provisions addressing “Confidentiality”, “Exclusivity” and this final paragraph, which will each be binding upon the parties and enforceable in accordance with the terms set forth herein, the provisions of this LOI are not intended to be a binding or enforceable agreement and the parties contemplate that they will become legally bound only if, as and when the transaction documents are executed and delivered by the parties.”