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Many companies have found that raising venture-capital funding is not as easy — or even as likely — as it was a few short years ago. While this investment climate holds especially true for technology companies without earnings, it has cut across industry lines. Many venture investors seem determined to stay on the sidelines as a matter of principle while valuations and business prospects continue to seek equilibrium. However, some investors have continued to fund companies, in many cases at “bargain” valuations, driven by an undersupply of venture dollars. Such a “bargain” transaction might qualify as a “down round,” which in simple terms is an equity financing at a price per share that is less than what was used in a company’s previous financing. VentureOne estimates that in 2001 there were approximately 2,927 venture financings that raised approximately $33.6 billion in funding. A significant percentage of these are thought to have been down rounds. See www.ventureone.com. Down rounds present special risks to venture investors and corporate management; therefore, each must approach the negotiation and approval of a down round with caution. At its core, a down-round financing resembles any venture-capital financing. Yet, during the period of weeks between the final term sheet and the closing of the financing, associated legal and other professional fees can balloon from what would normally be less than 1 percent of the total dollars raised to upward of 5 percent to 8 percent. This is largely the result of attorney time spent protecting against two significant and, at times, competing sources of issuer, director, officer or controlling stockholder liability: • To the extent that the participants in a down round include investors that are not “accredited” for the purposes of establishing a valid federal securities exemption (common in “rights offerings” made to every existing stockholder), securities exemptions may be costly to obtain or completely unavailable. • Existing stockholders, whose financial interests undergo massive dilution as a result of the low prefinancing valuations typical in down rounds, may make claims for fraud and breach of duty against directors, officers and controlling stockholders for allowing their interests to be eroded in the financing. An issuer may limit or dispense with the former risk by excluding some or all of the unaccredited investors from participation in the round, or by spending freely for the preparation of an offering document containing disclosures similar to those in a public-offering prospectus. RISK OF STOCKHOLDERS’ CLAIMS The latter risk is largely a retrospective one: whether the transaction was the product of fair dealing and fair pricing. These concepts are much more subtle and in certain respects mirror the public’s current “post-Enron” dissatisfaction with corporate management. Yet a corporate director deserves to be guided by standards better than “you’ll know fraud or abuse when you see it.” The general standards of fair dealing and fair pricing as tools for management and controlling stockholders have been regularly reported in state case law. Unfortunately, no reported cases address these standards in the context of a down round. The matter was litigated in the early 1990s, however, in what is the now-famous Alanteccase, captioned Kalashian v. Advent VI Limited Partnership, No. CV-739278 (Calif. Sup. Ct. filed March 23, 1994). Although the case settled before trial, the factual allegations and resolution have precipitated a list of dos and don’ts that lawyers should employ in order to minimize the risk of claims for fraud and breach of fiduciary duties in the context of a down round. What follows is a brief summary based solely on the plaintiffs’ initial complaint and on public information regarding its resolution, followed by practical discussion addressing risk management in light of Alantec. In May 1987, the plaintiffs formed Alantec Corp., a developer of ethernet local area network switching equipment. In mid-1988, a prominent Silicon Valley venture capital (VC) fund invested in Alantec’s first, or “Series A,” venture-capital financing and designated a representative of the fund to serve on the Alantec board of directors. Then, in July 1989, this investor, together with two additional VC funds, committed to make a Series B investment, conditioned on Alantec agreeing to a standstill agreement to prevent it from seeking alternative sources of funding. In the months leading up to the Series B financing, Alantec hired an “interim CEO” approved by its Series A investor. The interim CEO then allegedly reduced Alantec’s sales projections by 50 percent and circulated the new projections to the board. The plaintiffs contended that Alantec’s gross sales had allegedly doubled from quarter to quarter in 1989 and exceeded $500,000 for fiscal year 1989, which would have called into question the revised projections and cut in favor of a higher Series B price. In December 1989, Alantec closed its Series B round, but at approximately one-third of the price per share agreed to in the July 1989 term sheet. In the financing, the participating VC funds appointed additional directors and had also collectively obtained a controlling interest in Alantec’s shares. In June 1990, the VC-controlled board terminated each of the plaintiff company founders. As of their termination, the plaintiffs collectively held approximately 8 percent of the company. All outstanding common and preferred shares held as of the termination date then underwent massive dilution as a result of issuances to management of options to purchase millions of shares and the sale of close to $10 million of preferred stock. During this period, Alantec’s profits allegedly jumped 678.8 percent, in part as a result of its late-1991 release of a new product line. In February 1994, Alantec had its initial public offering (IPO). At the time of the IPO, the plaintiffs collectively held 8,636 shares, or 0.0078 percent of the company. Then, in mid-1996, Fore Systems purchased Alantec for $770 million, yielding a mere $600,000 for the plaintiffs. THE ISSUES IN ‘ALANTEC’ The defendants fell into two categories: officer, “interested” director and controlling shareholder defendants; and “disinterested” director defendants. The plaintiffs sought compensatory relief from the first group based on conspiracy to commit fraud and breach of fiduciary duties arising from the post-termination issuance of new shares at below fair market value, and the refusal to allow the plaintiffs to participate in the dilutive financings. The plaintiffs sought declaratory relief from the second group of defendants to prevent Alantec from upholding indemnification obligations to the first group of defendants because their actions included intentional misconduct, were contrary to the best interests of the stockholders, were taken in the absence of good faith and improperly benefited the indemnitee. In May 1997, after extensive pretrial motion practice, the case reportedly settled for approximately $15 million. SeeAlex Gove, “Washouts Take a Bath,” Red Herring, December 1999, www.redherring.com/ mag/issue43S/bath.html. It is not known whether the company made good on its promises to indemnify its interested directors, officers and controlling shareholders. The most effective way to dispense with Alantecrisk is to adhere closely to the approval requirements under the applicable “interested director” statute. Under Delaware law, no interested director transaction is either void or voidable so long as one of following is true: • The material facts and any interested director’s interest are fully disclosed or known to the board or its committee, and the board or committee approves the transaction in good faith by a sufficient vote without counting the vote of any interested director; • The material facts and an interested director’s interest are fully disclosed or known to the stockholders, and the transaction is approved by a majority of the stockholders in good faith; or • The transaction is fair to the corporation at the time it is approved. FOCUS ON FAIRNESS California law imposes a more stringent test on interested director transactions. The “fairness” of the transaction is a necessary but not independently sufficient criterion for a valid board approval of a down-round transaction. As a fallback, California law provides refuge when in litigation the defendant director, officer or controlling shareholder sustains the burden of proving that the transaction was just and reasonable at the time it was approved. What is “fairness”? Most jurisdictions apply the “entire fairness” standard to transactions when directors or controlling stockholders stand on both sides of a transaction. Entire fairness under Delaware law has two components: fair dealing and fair price. Fair dealing includes matters of timing, initiation, structure, manner of negotiation and manner of obtaining director and stockholder approval. Initiation of a transaction by a controlling stockholder, standing alone, is not incompatible with the concept of fair dealing so long as the controlling stockholder does not dictate the deal terms or gain financial advantage at the expense of the controlled corporation. Fair price requires that the price per share obtained be the highest value reasonably available under the circumstances, whether or not it is a “screaming bargain.” In an otherwise nonfraudulent transaction, price may be the preponderant consideration. In a challenge by minority stockholders, the burden typically rests on the board or controlling stockholder to prove that the transaction was entered into at arms’ length and in good faith, and to show its inherent fairness from the viewpoint of the corporation and those with an interest in it. The initial burden may rest on the defendant directors, but the transaction will be upheld if it can be established that the action was fair to the company at the time it was approved. PRACTICAL CONSIDERATIONS There are a number of tools that a company can and should implement to mitigate Alantecrisk: • Document the business rationale. Have the board and committee minutes include a detailed “paper trail” that supports the business rationale and valuation for any dilutive financing. • Seek approval by a majority vote of the board, with interested directors abstaining. If only one director, or a small number of directors on a larger board, has a conflict of interest, a majority of the board may approve the transaction. In that situation, the interested director should fully disclose the conflict and the relevant facts, and, when appropriate, abstain from the discussion. • Seek approval by a special committee. The board may appoint a special committee composed of disinterested and independent directors. The committee should be permitted to seek outside legal counsel and financial advisors if appropriate. The board may either delegate the final decision to the committee or ask the committee to make a recommendation to the board. • Fully disclose conflicts of interest to the approving stockholders. If all or nearly all of the directors have a conflict of interest, the disinterested stockholders may approve the transaction after full disclosure. The disclosure should describe the transaction and detail the directors’ and shareholders’ material conflicts of interest. Note that VC funds may not favor detailed disclosure of these highly sensitive facts. • Determine that the transaction is fair. Seek external sources to establish the overall fairness of the transaction. A hired consultant can pass on the fairness, but at significant cost. Prior unsuccessful fund-raising efforts and the absence of competing term sheets by other VCs are also suggestive of the fairness of the down-round valuation. Note that this does not address the “fair dealing” element of the overall fairness test. • Conduct a “rights offering.” If existing stockholders in a dilutive financing have the opportunity to maintain a pro rata interest through a new investment, it is difficult for such a holder to claim harm as a result of dilution. Unfortunately, not every existing stockholder who receives an offer or makes an investment is likely to be an accredited investor, which may render commonly relied-upon federal and state securities exemptions unavailable. • Provide directors and venture investors with indemnification agreements. Many down-round participants now require that the issuer indemnify new directors and large stockholders against Alantecliability. Such protection is intended to shield stockholders against the disgorgement that occurred in Alantecand shift all of the up-front litigation costs to the issuer. Yet situations such as a down round, which by their nature may involve allegations of fraud and unfair dealing, call into question the enforceability of contractual indemnification. • Fund a new enterprise for the sole purpose of acquiring the issuer’s assets. Rather than live with the risk of a dilutive financing, a new entity may purchase assets and operate with a clean capital structure. In any such transaction, external valuation of the assets will be critical, and the transaction may be complicated by legal issues including dissenters’ rights. While it may be easy with hindsight to identify some of the “bad facts” that bolstered the Alantecplaintiffs’ case, most companies faced with completing a down round in this inhospitable funding environment may share traits and face the same practical challenges. However, with active consultation among management and outside counsel, a company should be capable of properly establishing that a down round was the product of fair dealing and came at a fair price. Unfortunately, the cost of preserving federal and state securities exemptions may be extremely high under these circumstances. In the end, issuers can manage Alantecrisk and abide by securities laws by undertaking a costly and detailed rights offering. An alternative and cost-saving strategy, omitting unaccredited stockholders from the offering, gives rise to Alantecliability to those omitted. Challenging circumstances do in fact necessitate careful strategies for continuing success. William M. Kushner is a partner in the Menlo Park, Calif., office of Seattle’s Perkins Coie ( www.perkinscoie.com). He handles general corporate and finance matters for his clients, which consist of high-technology, biotechnology and equipment-leasing companies as well as venture capital funds and investment banks.

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