Governance, Fiduciary Duties & Board Hygiene

Don't Forget to CYA the File, Founders

There's a steep cliff between seed and Series A, and it produces more distressed sales than most founders expect.

During the 2021 boom, roughly 50% to 60% of seed-backed startups successfully graduated to a Series A. Today, the market has dramatically tightened, and anecdotally, we’re seeing 1/4 or 1/3 of seed-backed startups successfully make it to Series A if they’ve raised $3-4M in SAFE note financing only. Usually for companies that raised $3-4M in SAFEs, they’ve built something real and marketable — an IP portfolio, some customers, real founder expertise, but maybe for reasons out of their control, couldn't graduate to a priced round.

The most common exit at this stage is an asset sale plus an acquihire, which is fast and relatively simple to execute. The catch is that some of these companies did not purchase D&O insurance yet so founders have zero cushion if they're later accused of breaching their fiduciary duties in how they handled the sale.

For those who did purchase a baseline $1M D&O insurance policy (if mandated by their seed investors), those basic limits are easily drained by legal defense fees if founders are later accused by disgruntled common shareholders or wiped-out SAFE holders of breaching their fiduciary duties during the sale.

That makes process the whole game:

1. Engage a qualified financial professional (examples: CPA firms, business brokers, or bankers are common professionals our clients talk with) early to establish a real fair-market-value benchmarks.

2. Document every alternative you actually considered and discussed during Board meetings, whether that's a bridge round, another priced round financing attempt, or other buyers who fell through.

3. Where possible, get a fully informed, un-coerced disinterested stockholder vote approving the deal — that alone can shift legal review back to the deferential business judgment rule instead of the much tougher entire fairness standard.

4. Confirm your charter's exculpation provision is actually in place, and that indemnification agreements are individually signed with each director and officer — don't assume bylaws alone will cover you, especially if there was an amendment that removed the standard indemnification provision.

5. Keep Board minutes contemporaneous and thorough — the evidence of good-faith, informed decision-making is ideally in the minutes showing real-time deliberation during the meeting, not a tidy story reconstructed after a demand letter shows up

Transcript:

Lindsey Mignano:

Hi everyone, Lindsey Mignano here. I've got Nicola here again with me to talk today about distress sales — something that happens more often than you think at seed. And by seed, we really mean a SAFE note seed.

It happens often to our clients. Let's say they raise three to four million in SAFE notes. They're doing okay for a while, but they just can't graduate to that priced round. Whether that's a Series Seed or a Series A. There is a steep cliff when we are looking at seed to a transition, and so there's quite a bit of distressed sales at the seed stage as a result.

They've definitely got something there: they've got an IP portfolio, they've got trademarks, they've got a platform as a service or a software as a service that has some customers, and they've got founders with know-how and expertise in that one area. So they've got something, and usually the most common type of acquisition we see at that stage is an asset sale plus acquihire, and that's relatively easy to accomplish and quick to accomplish.

But there are, of course, certain rigamarole that any startup has to go through when they're considering this process, right? Unfortunately, they don't have a D&O insurance usually at this stage — something that usually comes in, because it's so expensive, at Series A or above — so there's no D&O insurance just in case they somehow breach their fiduciary duties. They really want to be as careful as possible as a result.

So, what we normally see them do is engage a business broker pretty early on to help them develop an idea about what fair market value could be for this distressed sort of sale. They may consider a bunch of alternatives, like maybe not even a sale, and then of course document all of those different alternatives.

It could be a bridge round. It could be another venture round. It could be a number of different potential sales that fall through, but they're definitely documenting the record. And they're having similar conversations with their peers or their I bankers or their CPAs about how other people are structuring things and how much they're selling for.

Ideally, it's an independent financial adviser. I really love a CPA or an I banker who's helping with the sale, or a business broker who's helping with the sale, who's giving them an idea of what the market can bear and documenting that. So, that's something that we see them do quite often. I think there are also some legal things they should be doing. And I've got Nicola here to talk a little bit more about what are those items that we can do from a corporate housekeeping perspective just to make sure that no one breaches their fiduciary duties as a director and officer of this company, and to make sure that they can all cleanly exit and sell this IP, give whatever they can back to their shareholders. Nichola, go ahead.

Nichola Xani:

Yeah, absolutely. So, I would say first on the list would be to get a fully informed stockholder vote where you can.

So a properly informed, uncoerced stockholder vote approving the transaction can itself be cleansing, pushing review back to the deferential business judgment rule rather than entire fairness, is kind of what you get when you get the informed stockholder vote.

And you want to make sure that the proxy and information statement to stockholders discloses the material facts, including any board conflicts, so the vote is actually informed for these purposes.

And then you want to confirm exculpation and indemnification are actually in place. These are most likely already in your bylaws. Some of the incorporation companies actually provide this both in the bylaws and in the charter. So you just want to make sure that your charter has the expulation provision that shields directors from personal monetary liability for breach of the duty of care, though not for a breach of the duty of loyalty, bad faith, or intentional misconduct.

And you also want to confirm that indemnification agreements are actually signed with each director and officer individually. So, we help draft indemnification agreements all the time. You want to ensure that those are actually in place for when something like this comes up, and you don't want to just rely on the bylaws provisions that could theoretically be amended later.

And then lastly, you want to keep the board minutes contemporaneous and thorough. And the single biggest determinant of whether a court finds good-faith informed decision-making is whether the minutes actually show the deliberation happening in real time, not a tidy narrative reconstructed after the demand letter arrives.

Lindsey S. Mignano:

Yeah, usually most of our clients, as they're exploring different alternatives, whether it's a bridge round of financing or selling to multiple other parties in the past, they do document these things in their board meeting minutes so that in case it ever came up in the future that the directors were either lazy or self-interested in entering into the instant sale, they have a record of all the other things that they tried, right?

And so this is really just a matter of making sure that you're documenting, where you can, as much as you can, to protect your own self as a director and officer of the company from being accused of not doing a very good job in selling what you can at the highest price possible on the market.