appealing offer to buy a company. In this situation, the founders, the common shareholders, the early investors (let's call them Early VC), and the employees will make a nice return. However, the last-round investor will only get its money back. While the company can continue to operate for a year with the cash in the bank, the founders and early investors decide they would like to sell the company. However, the last-round investor (let's call the firm Late VC) doesn't want to sell.
Late VC previously negotiated blocking rights as part of its protective provisions (in the financing documents) on the sale of a company for less than 1.5× their investment. This disagreement is the first time this particular issue has come up, and no one other than the Late VC realizes that Late VC can block the transaction using its protective provision.
The board discusses the transaction extensively, with Late VC insisting the company should keep running independently for at least another year, given the potential future opportunity. However, the founders and Early VC want to cash in. Not realizing that Late VC has blocking rights, Early VC says, “Let's put it to a vote.” The founder/CEO forgot to invite outside counsel to the board meeting, so no one reminds the board members of Late VC's blocking rights.
In this situation, there's a board vote and, while Late VC votes against the transaction, a majority of board members vote to sell the company. However, Late VC says, “Hang on a second, I'm going to exercise my preferred right to block the sale of the company.” Everyone looks at each other angrily. Early VC rolls out the phrase “fiduciary duty” and angrily tries to school Late VC, who is very experienced, that Late VC has a fiduciary duty to all shareholders. Late VC smiles coyly and counters that it also has a fiduciary duty to its limited partners and is protecting that duty by exercising the protective provision it negotiated as part of the last financing round.
Eventually, one of the founders says, “Late VC board member, what do you want?”
Late VC responds, “At least 1.5× my investment or let's keep running the company since we have plenty of cash on the balance sheet—the cash that I recently gave you!”
It's worth recognizing the Late VC could have also voted, in its capacity as a board member, for the transaction but then exercised its protective provision separately to block the transaction from proceeding.
There are multiple solutions to this situation. But understanding the potential conflicts early, especially in any transactional situations, and having open discussions about how to resolve them that include the advice of counsel are the best approach.
Benefit Corporations and the B Corp Movement
Until recently, U.S. corporate law wasn't structured to address the situation of for-profit companies that wanted to pursue a social or environmental mission. While corporations generally can pursue a broad range of activities, corporate decision-making is justified through creating long-term shareholder value.
Benefit corporations, often called Public Benefit Corporations (PBCs) because of the Delaware legal framework, expand the fiduciary duty of directors to require them to consider non-financial stakeholders and shareholders, creating legal protection for directors and officers to consider additional stakeholders. Currently, 35 states and the District of Columbia include state laws for benefit corporations.
Benefit corporations don't differ much from traditional C corporations. Changing to a Benefit Corp from a C Corp is straightforward and simply requires a change to the corporate bylaws. While third-party certification isn't required, many companies choose to be certified by the non-profit B Lab to meet rigorous social and environmental performance standards, accountability, and transparency. Brad's VC Firm, Foundry, became a B Corp in 2016 and has been a B Corp advocate since then.1
At the core of the B Corp movement is the idea that all companies share a duty to build responsible businesses for their employees, customers, and communities. There's a current view that businesses that treat their constituents well can attract and retain employees better, innovate faster, grow more quickly, and create more value. Additionally, some entrepreneurs assert that they are trying to create a better world through the daily actions taken by their businesses. By integrating responsible practices throughout an organization, companies can build better businesses while at the same time being agents for positive change.
While B Corps require a different philosophy of governance than LLCs or C Corps, the board's general role and attributes are similar. Consequently, the fundamentals of building and leading a board of directors remain the same.
Should You Get D&O Insurance?
In conducting board duties, numerous decisions have to be made. Directors aim to function with transparency and conduct their affairs in the most diligent manner, yet certain outcomes can lead to lawsuits. It's an occupational hazard.
Issues may arise from existing shareholders who believe that the directors didn't act in the interest of all shareholders or get appropriate approvals. In certain situations where the corporation fails to meet its federal or state obligations, such as taxes, environmental safety, or occupational health, the government can initiate action against the corporation. Former employees can sue directors for a variety of reasons.
Corporations indemnify their directors and officers through their bylaws and indemnification agreements with individual directors. Indemnification is the first line of defense for both your board of directors and your officers. Indemnification includes expenses (including attorney's fees), judgments, fines, settlements, and other amounts reasonably incurred with any proceeding, arising because such person is or was an agent of the corporation.
However, startups are generally cash-constrained, and any legal action will impact already scarce cash resources. As a result, the second line of defense is a solid D&O (directors and officers) insurance policy. Such a policy helps preserve corporate funds. In certain situations, corporations become insolvent and yet have lawsuits lingering on. D&O insurance becomes the only source of your legal defense funds in these situations.
D&O insurance offers protection to the board of directors and the corporation's officers. Insurance pays for defense costs and can cover some or all damages. Early-stage (pre-revenue/product development) startups should aim to procure between $1 million and $3 million in coverage, typically costing $5,000–$10,000 per year. As the company matures, these amounts should be revisited and increased for the actual size of the company and current market norms.
D&O policies will have several variables, including the scope of coverage, the annual premium, deductibles, limits on the maximum amount covered, and the term of coverage. As with any insurance policy, you should negotiate carefully with several vendors. At the minimum, make sure you understand what the policy covers concerning the following:
Director and officer wrongdoings within specific terms. The policy definition of “wrongful acts” needs to be understood clearly by each director. Fraud or criminal conduct may be obvious. On the other hand, negligent acts or “intentional harm” can fall into the subjective category. Also, the insurance should cover directors from the actions of other directors or officers. Minor changes in policy language can have a significant impact on costs.
The cost of indemnifying directors and officers.
Defense costs only or defense and damages? Watch for limits and exclusions. The broader the coverage combined with limited exclusions translates to a high premium.
Exclusions state things not covered by the insurance policy. These can include misconduct, blatant fraudulent acts, willful breaches of laws,
