Pay-To-Play, A-OK

Two recent Delaware cases permitted merger transactions to proceed despite the fact that the sole purpose of the merger was to circumvent the consent rights of stockholders who opposed amending the company corporate charter to allow a "down round" rights offering to existing shareholders.

This article from Faegre & Benson explains:

"For start-up companies, cash is life and a lack of cash often means death. When things don't go well at a start-up, the critical next round of financing usually comes mostly (or entirely) from the company's existing or "inside" investors.

Inside financing rounds can raise a thicket of legal and practical issues, including claims of self-dealing or breach of fiduciary duty, because the inside investors typically have seats on the company's board and often have majority control of the board. Those issues can be especially acute when the inside financing is a "down round" or if it includes a 'pay-to-play' feature that adversely affects any stockholders who do not participate in the proposed deal.

Two court decisions from Delaware, WatchMark Corp. (2004) and Benchmark Capital (2002), provide some helpful guidance to companies trying to secure financing in an inside round. Those decisions are also a cautionary note to venture capitalists and other investors who might be opposed to a particular inside, down or 'pay-to-play' round."

The lessons from the cases according to the article

"1. Charters Need to be Drafted Carefully...

2. That Applies to No-Impairment Clauses Too...

WatchMark makes clear that no-impairment clauses, like other preferred stock provisions, will be interpreted very strictly. A catch-all “no-impairment” clause will not make up for careless drafting.

3. Endorsement of Participation Rights and Pay-to-Play Fairness...

After WatchMark, we would expect rights offerings to become even more of a standard feature in down, inside or pay-to-play financing rounds...

4. The Importance of a Good Record.

As is often the case in Delaware corporate law case decisions, WatchMark highlights the importance of making board decisions in the right way and carefully documenting this process for the record."