A recent decision by Delaware’s Chancellor Bouchard, Carr v. New Enterprise Associates, Inc., highlights the potential governance challenges and risks that arise in two financing scenarios encountered by emerging companies, including those backed by venture or private equity funds.

The first scenario involves the inside financing round. A technique common to venture and growth equity-backed companies, the inside financing round involves the sale of equity (usually preferred stock) or convertible debt securities to the company’s existing venture capital or other institutional investors, such as a private equity fund that has previously provided growth equity capital.

Because venture and other institutional investors typically have representatives on the company’s board of directors pursuant to contractual rights and/or rights granted under the company’s charter, an inside financing round usually represents an interested director (i.e., conflict of interest) transaction and may—depending on the lead inside funder’s ownership position before the financing is consummated—represent a transaction with a controlling stockholder.

Inside financing rounds present to directors and their advisors the puzzle of what process the board should follow to demonstrate—should the transaction be challenged by disgruntled minority stockholders—that the directors have satisfied their fiduciary duties in approving the inside funding round. By identifying and following an appropriate process, directors and their advisors can insulate the transaction from invalidation and protect the directors from personal liability.

The second scenario involves a financing transaction where the lead funder (often a strategic investor) makes an investment that includes an option or other right to acquire a controlling stake in the company or acquire the company outright. This is encountered, for example, by distressed pre-public companies as well as by emerging companies in the life sciences industry.

While the option does not represent an immediate sale of corporate control, it may afford the option holder the ability to acquire corporate control in the future (sometimes subject to conditions). Such transactions present the board with the question of the optimal process for considering and approving the financing and what standard of review a court will apply if the transaction is challenged in court by disgruntled stockholders.

The Carr case involved both of these challenging transactions: a preferred stock financing of Advanced Cardiac Therapeutics, Inc. (“ACT”) led by an existing venture capital investor and, only months later, a transaction that involved the issuance of a warrant to a strategic investor that, if exercised, would result in the strategic investor’s purchase of ACT.

This article provides an overview of the key issues litigated in the Carr case, summarizes the governance-related legal principles relevant to directors who serve on the boards of venture and other privately funded companies considering these transactions, and offers practical tips for the approval process that may help to ensure that the transactions withstand a legal challenge mounted by minority stockholders.

Read the full article here.