How can a board decrease litigation risk in an insider-led down round or dilutive financing?

Takeaway: Insider-led down rounds can expose a startup to litigation risks due to potential conflicts of interest. These risks can be mitigated through careful measures including full transparency, the engagement of independent financial advisors and board members, establishing a special committee of independent board members, seeking minority stockholder approval where appropriate, maintaining detailed records of all related discussions and decisions, and obtaining sound legal advice throughout the process.

Insider-led down rounds are situations where existing investors lead a round of financing at a valuation lower than the previous round. While these rounds can provide much-needed capital for the startup, they can also increase the risk of litigation due to perceived conflicts of interest. This article will discuss strategies for a startup's board of directors to mitigate litigation risk in such circumstances.

Full and Fair Disclosures

Transparency is paramount in mitigating litigation risk. The board should provide complete and accurate information about the financing to all stockholders, especially about the valuation and dilution impact. Providing all stockholders with the same information allows them to make informed decisions and can help prevent claims of unfair or deceptive practices.

Engage Independent Financial Advisors

Having an independent financial advisor conduct a fair market valuation of the company can add credibility to the process. Their impartiality can help insulate the board from claims that the valuation was manipulated to favor the insiders. The advisor can also provide an opinion on the fairness of the transaction from a financial point of view.

Independent Board Members

Having independent board members (those not affiliated with the insider investors) involved in approving the financing can help mitigate conflict of interest concerns. These board members should actively participate in negotiations and decision-making regarding the down round, providing an impartial perspective.

Establish a Special Committee

In cases where there may be significant conflicts of interest, the board can establish a special committee made up of independent directors to review and approve the transaction. This committee would be vested with the power to negotiate terms and potentially even explore alternative financing options.

Minority Stockholder Approval

In certain cases, obtaining approval from disinterested minority stockholders can provide an additional layer of protection. While this may not be feasible or practical in all situations, it can demonstrate the board's commitment to fair and transparent practices.

Detailed Record Keeping

The board should keep detailed records of all discussions, negotiations, and decisions related to the down round. This includes meeting minutes, emails, and any other correspondence. Having a record of the process can be helpful in defending against any future litigation by showing that the board took all necessary steps to ensure fairness and acted in the best interests of the company.

Legal Advice

Finally, obtaining sound legal advice throughout the process is crucial. Legal counsel can help guide the board through the complexities of insider-led down rounds and provide strategies to mitigate litigation risk.

Conclusion

Insider-led down rounds can be a lifeline for startups in challenging times, but they need to be navigated carefully. By implementing these strategies, a startup's board of directors can help reduce litigation risk and protect the interests of all stakeholders.