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Recent decision by Massachusetts Supreme Judicial Court Strictly Construes Transfer Restrictions and Co-Sale Rights in S Corporation

Posted on Apr 19th, 2013

 

Since the 1974 landmark decision in Donohue v. Rodd, Massachusetts courts have held that majority stockholders in close corporations owe minority stockholders a fiduciary duty akin to that owed in a partnership. This type of duty has been relied up to protect minority shareholders from squeeze-out or freeze-out scenarios. It has also been used as an offensive tactic to argue for implied rights of shareholders that are not expressly provided in the corporate documents, such as the articles of organization, bylaws or shareholder agreements.

In Merriam, et. al. v. Demoulas Supermarkets, Inc., the Supreme Judicial Court refused to extend the duties provided under Donohue v. Rodd to restrict stock transfers that were not expressly restricted under the Corporation’s governing documents.

While a fiduciary duty may exist, the Court encouraged shareholders of close corporations to enter into a shareholder agreement or specify in the corporate bylaws “rights, protections, and procedures that define the scope of their fiduciary duty in foreseeable situations.” The Court held that good faith compliance with the specific terms will not implicate that fiduciary duty. “A claim for breach of fiduciary duty may arise only where the agreement does not entirely govern the shareholder’s actions.”

In this case the plaintiffs attempted to use the concept of fiduciary duty in a creative way to prevent the transfer of stock because the corporation was an S corporation and the transfer could blow the S election. After reviewing the shareholder agreement and bylaws, the Court held that the challenged actions fell within the scope of those agreements – which did not restrict such a transfer – and that the fiduciary duty was not implicated in this case.

The court also rejected the argument that the fiduciary duty could be used to create an implied right of first offer or co-sale rights on a transfer to a third party. Transfer restrictions are to be construed narrowly in Massachusetts, and the Court reasoned that had the parties intended to create such rights and restrictions, they would have stated so expressly in their shareholder agreement.

Certainly, this decision does not present any major news to most corporate practitioners. While it is nice to know that shareholder agreements are still given weight in Massachusetts, the key takeaway is the importance of having such an agreement in the first place. Close corporations, particularly those with employee shareholders, should be strongly encouraged to enter into detailed shareholder agreements to provide for situations dealing with transfers, rights of first refusal, preemptive rights and potential divorce and dissolution. Majority stockholders may feel some reluctance to spend money and time on such a document, when the protection is often for their fellow stockholders. However, as shown by this decision, not having such an agreement will subject everyone to the vague principles of applicable fiduciary duties, which could have wide-ranging and negative implications.

If you have any questions about this topic, please feel free to email us.


Some Thoughts on Convertible Notes vs. Straight Equity

Posted on Mar 15th, 2013

In today’s early stage fundraising market, most seed investments come in several flavors: common stock, convertible notes (or “converts” as they are sometimes called) and a simple preferred stock investment. There are a lot of interesting posts on this topic on Quora and elsewhere so we thought that we would provide our take.

Common Stock

If you are looking for a simple and inexpensive process and you are raising a small amount of money ($250,000 or less), common stock may be a good choice. The documentation can be very simple – a short subscription agreement (with an investor questionnaire), shareholder agreement, stock certificates and you may be done. Typical terms include basic information rights, rights of first refusal and co-sale (or tag along) rights and a pro-rata right to participate in the next round of financing of the Company. From the company’s standpoint, it is generally a good idea to keep these deals as simple as possible, both to keep costs down and to avoid a complicated structure that could impact future investment rounds. If the company is an S-corporation, a common stock round (assuming all investors are eligible S-corp shareholders) also helps the company to keep its S-corp status, which can create tax benefits for active investors and founder shareholders.

The downside of an early common stock round is that it can lock the company into a fixed valuation that has not been really tested by the market. If the valuation is set too high, it will be difficult for the company to issue cheap stock and options. Since this is often a key attraction in joining a company at an early stage before they raise a larger capital round, an excessively high valuation could prejudice the company in attracting key talent at this formative stage. Another downside to a fixed price is that follow-on investors may challenge the valuation that was reached and try to impose a lower valuation—a down round—later. This potentially puts the company in the awkward position of mediating between the original investors and the new money. The original investors, of course, put their money in at a higher risk and may insist on their negotiated deal. The new money may want to pay less and thereby substantially dilute the original seed investors. Unlike a preferred stock or convertible note structure, common stock usually does not offer a simple price protection (like a weighted average broad based anti-dilution adjustment).

If the common stock value is too low, it may be unfair to the founders and key employees. This issue may take awhile to germinate, but by the first or second venture round, there may be pressure from management and the new investors to try to “reshuffle the deck” to get the key players more of a stake in the Company’s long term outcome.

Convertible Notes

There a lot of variations on this deal structure. Over the last several years, the most prevalent terms include an unsecured note carrying a 24-36 month term, interest ranging from 5-10%, and a conversion price based on the next “Qualifying Financing” of the Company (usually $1-2MM of new money). The conversion price is now often subject to two outside conditions that help reduce some of the uncertainty of the valuation of the Qualified Financing by subjecting it to a cap and a discount of the price in that round. The cap can range from $1-2MM on low end (considered low) to $7-8MM on the higher end (this range is usually seen where the Company already has some traction or where the founders are known players and therefore able to command better terms). The discount ranges from zero to 30%, usually being in the realm of 10-20%. Similar to common stock terms, investors usually get basic information rights and pro-rata participation rights for the company’s next financing round.

The documentation for these deals also tends to be pretty light, and while a bit more than the common stock offering, a lot less than a preferred stock investment. Typical documents involve a subscription or purchase agreement and some form of convertible note. Deals can also include warrants, although this seems a bit less common in today’s market. Similar to a common stock round, these deals can be closed quickly and cost-efficiently.

Like the common stock deals, a downside of convertible notes for the company can arise at the time of the next round, if the new investors see the terms as being too rich and do not want the old investors converting into the same security as them, and at a lower price. This issue has caused many sophisticated investors to opt for more set terms on valuation, resulting in the recent popularity of preferred seed rounds, discussed below.

Series Seed or Series A-1 Lite Preferred Stock

Because preferred stock investments are significantly more complicated to close than the other deal formats, a number of national law firms and investor syndicates have tried to develop a simple set of deal documents to make this structure more attractive. (See Fenwick & West Series Seed Docs for example.) While we commend these authors for trying to establish an open-source library to streamline this process and reduce expenses, these documents are basically a watered down version of other more comprehensive VC form documents, such as the NVCA Model Documents, and leave a lot of details out that could be material. For a small amount of investment — $500,000 or less — it would seem hard to justify this structure. Also, if the Company is an S-corp, it will automatically blow the Company’s S-corp election, something that may be better delayed until the investment amount is substantial and merits losing the single-tax structure. The creators behind the Series Seed argue that those documents can be just as fast and cost-effective as convertible notes, with the added benefits of giving “investors more clear definition around rights, more stability and less potential squabbling in the next round.”

The bottom line is that no structure is perfect and there are tradeoffs for all of the parties involved. While there are lots of free (and freemium) resources available to help educate entrepreneurs on these issues, experienced counsel should be sought to help document any transaction and ensure that it is done properly. All of these structures are designed to be cost efficient, to reduce the inevitable temptation for clients to do it themselves, and to allow folks with little or no money to establish the right foundation for their investment that will facilitate their growth and future investment potential.

If you have any questions about this topic, please email us.