A Case for Precise Drafting in Venture Capital Investments

The firm recently ran into an interesting drafting oversight that could have proven costly to several venture capital firms who had invested in preferred stock issued by one of our clients.  As with many venture capital investments, these institutions had acquired various classes of convertible preferred stock.  One firm, in particular, had successfully negotiated special rights to block certain mergers by the company or certain changes in the rights of the preferred - or so they thought!

On an as converted basis the venture capital firm in question held less than a majority of the voting securities of the company.  As a result, the other shareholders had sufficient votes to approve a merger of the company.  The venture capital firm's protection was in the form of an executive committee of the board that was required to approve any merger transaction by a unanimous vote.  The venture capital firm had a seat on that committee, but had vacated the seat for liability and other reasons.  Furthermore, the venture capital firm failed to negotiate any right to receive notice of committee or board meetings.  Therefore, a merger proposal could be considered and approved by the committee and the board before the venture capital firm would even know it had occurred.  Of course, the venture capital firm would receive notice of the shareholders meeting to approve the merger, but the firm did not hold sufficient votes to block the transaction, unless it required a special class vote.

The merger in question provided that the company would be merged into a new entity, financed by a friendly shareholder, but the preferred stock, including that of the venture capital firms, would be converted into common stock, thus losing their preferential rights.  The venture capital firm asserted that the merger was an indirect amendment of the terms of the preferred stock and, therefore, required a separate class vote of the preferred stockholder under Delaware corporate law.  Fortunately, there was a case on point.

In 1998, the Delaware Supreme Count considered a similar question in Elliott Associates L.P. v. Avatex Corp.  There the corporation's certificate included a provision that gave the preferred shareholder the right to vote on:

"(a) any amendment, alteration or repeal of the certificate of incorporation "whether by merger, consolidation or otherwise" that

(b) "materially and adversely" affects the rights of the ..[preferred]… stockholders."

The court held "when a certificate grants only the right to vote on an amendment, alteration or repeal, the preferred have no class vote in a merger.  When a certificate adds the terms 'whether by merger, consolidation or otherwise' and a merger results in an amendment, alteration or repeal that causes an adverse effect on the preferred, there would be a class vote."

In the court case, the preferred stockholder was fortunate because the precise language required by the court was present, thus requiring a class vote - in our case, the preferred stockholder was not so fortunate.

The lesson is clear.  For venture capital firms and other purchasers of preferred stock, precise drafting of the right to vote on alterations to the rights of the preferred stockholders is necessary or preferred stockholders may find themselves on the short end of a merger that has the effect of robbing them of their hard fought protective rights.