Publications: Are they worth the paper they’re printed on?

On Nov. 10, 2010, the Delaware Chancery Court issued a decision in SV Investment Partners, LLC et al v. ThoughtWorks, Inc. The decision calls into question the value of redemption rights for preferred stock, especially in situations where the company is not generating sufficient cash from operations to pay the amount of the redemption right.

In 2000, SV Investment Partners LLC and its affiliates (collectively SVIP) purchased almost all of the Series A preferred stock issued by ThoughtWorks Inc. (ThoughtWorks). The holders of the Series A preferred stock were entitled to an accruing dividend and, beginning five years after issuance, the right to cause ThoughtWorks to redeem their shares of Series A preferred stock and all accrued, but unpaid dividends “out of funds legally available therefor.”

SVIP exercised its redemption right soon after the fifth anniversary of the issuance of the stock. Since ThoughtWorks did not have the cash available to redeem SVIP’s Series A preferred stock, the corporation’s board of directors commenced a process to review the corporation’s finances every quarter to determine whether ThoughtWorks had sufficient cash for a redemption and whether a redemption would endanger the corporation’s ability to continue as a going concern. On several occasions, ThoughtWorks attempted to submit payment to SVIP in order to redeem some, but not all, of the stock shares that SVIP had tendered for redemption.

SVIP complained that this quarterly process was not sufficient and that the amount of “funds legally available” was much greater than had been determined by the ThoughtWorks board of directors. SVIP sued to demand a declaratory judgment of the phrase “funds legally available” and payment of the lesser of (i) the full amount of ThoughtWorks’ redemption obligation and (ii) the full amount of ThoughtWorks’ “funds legally available.”

Holding
The court held that ThoughtWorks was not required to immediately redeem the entire amount due as a result of the exercise of SVIP’s redemption right. The court engaged in a detailed analysis of the phrase “funds legally available,” noting primarily (i) that the meaning of this phrase is not equivalent to the corporation’s surplus, and (ii) that any payment that would render a corporation insolvent is impermissible as a matter of Delaware corporate law and, thus, not “legally available.”

The court went on to discuss the procedure pursuant to which the ThoughtWorks board of directors made its determination of the amount of funds that were available for redemption. The court noted that under Delaware law, when a board had engaged in determining whether funds are legally available, a dispute over that issue does not devolve into a miniappraisal. Rather, the plaintiff must prove that the board acted in bad faith, relied on methods and data that were unreliable or made a determination inaccurate as to constitute fraud. The court found that, to the contrary, ThoughtWorks board had acted responsibly and in the “utmost good faith,” going so far as to call the board’s process “impeccable.”

While the holding does bring home the relatively weak position that an investor faces when it has negotiated a stand-alone redemption right, it ultimately may not be that surprising. For example, commentary to the National Venture Capital Association’s Model Term Sheet states that “it is unlikely that the company will be legally permitted to redeem in the very circumstances where investors most want it.” However, even though the decision may not be surprising, it does starkly illustrate that redemption rights are an imperfect instrument that may be of little value to investors under certain circumstances and also demonstrates the challenges that an exercised redemption right may pose to the ongoing operation of a business.

Lessons for investors
Venture capitalists and other investors should take a number of lessons away from the decision. First, charters of existing portfolio companies should be reviewed to see if they may pose problems for investors seeking to exercise redemption rights, especially if the language of the charter suggests that the investor will not be able to exercise redemption rights when they nominally become available.

Second, when bargaining for the rights of preferred stock in future investments, investors should consider whether redemption rights, without additional protections, are sufficient (or even necessary) protection for the prospective investment. In its decision, the court pointed out that it is common to combine redemption rights with one or more protections (typically the ability to take control of the board and/or the ability to cause a sale of the company through the exercise of a “drag along” right, which allows the investor to sell its preferred stock and forces the remaining stockholders to do so on the same terms). The combination of these rights can lead to a better outcome for the investor, as they can greatly increase the likelihood of a liquidity event.

Last, for investors seeking even greater assurance of better remedies, an investor could invest in a target corporation via a completely different type of security, such as convertible debt or traditional debt with warrant coverage (although many other considerations would drive that investment decision.)

Lessons for venture-backed companies
Likewise, venture-backed companies should also take several lessons away from the decision. First and foremost: process matters. In the event that a corporation is faced with a claim for redemption, the board should take the matter very seriously, analyze the amount of funds available for the redemption carefully and take good faith action to repay the redeeming investor as funds become available.

Second, when negotiating with prospective investors, be cautious when discussing the availability and scope of redemption rights, if any. As the ThoughtWorks case illustr ates, they can create a heavy burden on the company if and when they are triggered. Further, make sure that the company fully understands the magnitude of the potential liability in the event that a redemption right is exercised. For example, if a preferred security will be entitled to mandatory accruing dividends, redemption rights would typically also apply to the redemption of these dividends — greatly increasing the company’s de facto debt load and the amount necessary to fully redeem the preferred stock.

Reprinted with permission of the Law Bulletin Publishing Company.