A Decade Later: Revisiting The Trados Case

Trados provided common shareholders with increased leverage to challenge sales transactions involving VC-backed companies, prompting VC funds to exercise greater caution in their exit strategies.

• This case serves as a reminder for private company directors to consider factors such as establishing a special committee and upholding the Revlon Standard when navigating transactions.

In the ever-evolving world of corporate law, certain cases leave an indelible mark on legal discourse. Trados, a Delaware Chancery Court case that unfolded a decade ago, is one such landmark. It involved a clash between venture capital funds and common shareholders, shedding light on the fiduciary duties of directors and the delicate balance between preferred and common stock interests. A decade later, we revisit Trados to examine its repercussions and enduring influence.

Background

Trados, a privately-held software company, found itself in the precarious position of holding a venture-backed "living dead" investment, where it was neither a clear winner nor a complete loss. The venture capital backers holding preferred stock decided to exit the investment and focus their resources elsewhere, while exiting they implemented a "management incentive plan" to motivate the new management team towards a sale, offering them up to 15% of the sale price. Eventually, the company was sold, but after paying management approximately $8 million, the remaining $52 million fell short of satisfying the preferred stockholders' liquidation preference, leaving common stockholders with nothing. 

In a legal battle following the Trados sale, common stockholders sued, contending that they received no compensation while the preferred stockholders benefited. The court emphasized that directors owe their fiduciary duties to common stockholders, not the preferred ones, whose rights are based on contracts. The directors involved in the sale had conflicts of interest as they were connected to the preferred stockholders or stood to gain from the management incentive plan. Consequently, the court applied a rigorous fairness test. The court determined that the process was unfair to common stockholders, as it was driven by the preferred stockholders' desire to exit without considering common stockholders' interests. However, the court deemed the sale price of $60 million fair, relying on the directors' valuation expert and discrediting the plaintiff's expert.

Serving Two Masters: Conflicts in VC-backed Firm Governance

Trados injected itself into the realm of Delaware jurisprudence by addressing a fundamental question: to whom do directors owe their fiduciary duties when faced with conflicts between common and preferred shareholders? Is it the corporation, the common holders, or the preferred holders who negotiate for board control? The court's ruling established a precedent that tilted the scales towards common-maximization. In essence, the court stated that boards, when exercising discretionary judgment, should prioritize the interests of common stockholders over the special rights and preferences enjoyed by preferred stock.

The Ripple Effect

A recent study conducted by Goethe University in Frankfurt delves into the profound impact of Trados on the exit decisions of venture capital funds, shedding light on the significant influence that legal rulings exert on market dynamics. Utilizing a rigorous difference-in-differences estimation method, the study meticulously analyzes the likelihood of sales-based exits for VCs nearing maturity compared to those further away, both before and after the Trados ruling.

The findings strikingly affirm that Trados has significantly bolstered the leverage of common shareholders, granting them the power to challenge sales transactions involving VC-backed companies. Following Trados, VC funds exhibit a heightened level of caution in their exit strategies, particularly when confronted with liquidity pressures. Trados has introduced a fresh dynamic that compels maturing VC funds to exercise greater prudence, steering them away from undervalued and detrimental sales that would disproportionately harm common shareholders.

Takeaways

In the final analysis, the Delaware Court of Chancery ruled that while the sale process of Trados lacked fairness, the price itself was deemed fair as the shares held no economic value. It can be described as a "no harm, no foul" outcome in common terms. Nonetheless, revisiting this case serves as a valuable reminder for private company directors to consider several important factors when navigating transactions.

For one, the establishment of a special committee composed of independent directors during the sale process is worth considering. This proactive step helps address conflicts of interest and ensures a transparent and impartial decision-making process. By adopting a worst-case perspective and appointing directors with no affiliations to venture funds, companies can minimize the potential for legal challenges and achieve better outcomes for common stockholders.

Moreover, upholding the Revlon Standard remains of paramount importance when embarking on a sale. Adhering to one's Revlon Standard duties not only mitigates the risk of post-sale litigation but also establishes a more favorable standard of review.

In navigating the intricate landscape of VC exits and dispositions in general, it is advisable to seek professional legal counsel to ensure a comprehensive understanding of fiduciary duties and best practices. For further inquiries, please contact Paul Marino (pmarino@sadis.com).