To celebrate the new year, I took a magic trip to the land of the Splash Brothers and Zuckerberg unbound (or perhaps untaxed). Most amazingly, everyone seemed to be riding a unicorn to fame and fortune.
I speak, of course, of San Francisco, where, in the midst of the tech boom, the hottest companies aren't traded on a public exchange. Uber, Airbnb, Palantir and others are private companies with valuations over $1-billion (U.S.) or, as they've come to be known, unicorns.
Unicorns are the most visible example of a recent trend: Companies that would have gone public a decade ago are choosing to stay private.
The reasons for this are well chronicled: compliance with public market rules – both securities laws and exchange rules – is expensive, the initial public offering process is time consuming, and (at least somewhat, though increasingly less so) founders who take their businesses public have to cede control. Public markets are great for cashing out, but some companies don't view them as great for putting money back into the business.
To grow big and strong, budding unicorns need cash. But traditional funding methods are an imperfect fit for young companies. Bank debt carries a high interest rate and equity investors dilute founders and share in the company's growth without contributing much more than, well, money.
Thankfully, places such as San Francisco, New York, and increasingly Toronto and Vancouver, are awash in venture capital money that brings a different, and more appealing, approach.
Venture capitalists, such as $600 cookbook author Nathan Myhrvold or Peter Gregory, bring ample funds and substantial expertise to young companies. However, young companies tend to be both inexperienced and risky. So, venture capital firms want common-share-like rights such as a say in major decisions and the upside if the pony develops into a grown-up unicorn, along with bond-like rights such as a consistent return, priority in bankruptcy or on a sale of the company, and the ability to exit their investment after a period of time.
Traditional modes of finance can't accomplish all of these things. Bonds have priority and a fixed return, but lack upside and leave the venture capital firm unable to exercise control. Common shares have all the upside in the world and carry voting rights, but don't offer a fixed return and are mostly illiquid (remember, there's no public market for these shares). And common shareholders are the last to recover in insolvency.
The solution to this problem is a finance jargon mouthful: Series A (or B, or C, or you get it) convertible preferred shares. These shares, like unicorns themselves, are a hybrid. Like debt, they carry a semi-assured return as, usually, they carry dividend rights that accrue and compound if the dividends go unpaid. Also, holders of these shares are entitled to be paid before the holders of common shares, both in the case of a sale of the company, an IPO, or insolvency. Like shares, they carry voting rights and board seats. If the value of the company grows significantly, they carry rights to convert to common equity and share in the full value of the company.
Like with Uber, preferred shares are practical, but our legal regime hasn't fully figured out how to treat them. Preferred shares have negotiated contractual terms (like bonds) but are governed by corporate law (like shares). This isn't a problem when things are going well and the company is generating cash, but, when a company is approaching insolvency, this chimeric nature has the potential to create real conflicts among unicorn (and wannabe unicorn) shareholders.
Take the recent case of former unicorn Good Technology, which was sold to BlackBerry for a mere $425-million in September. Had Good IPO'd at $1-billion, preferred and common shareholders would have shared equally in a tech bonanza. At $425-million, only the preferred shareholders recovered, leaving the common shareholders with nothing. Now, certain common shareholders in Good are suing Good's board for breach of fiduciary duty – in essence, for looking after the interests of the preferred shareholders at the expense of the common. As a company's value decreases, preferred shareholders have an incentive to salvage their investment, while common shareholders have an incentive to extend the life of the company.
You can see how this is a conundrum for a board of directors, especially in Canada. While, in the U.S., a board's responsibility is specifically to maximize the value of common equity, in Canada, a board must act in the best interests of the corporation. So, a board that approves of a sale that leaves common equity with nothing could be accused of acting in the interests of only the preferred shareholders, especially if preferred shareholders negotiated the right to appoint board members. Similarly, a board that chooses not to sell the company, but either doubles down on a risky strategy or effects certain share exchanges without obtaining the specific consent of the preferred shareholders, the preferreds would be left with diminished contractual rights and have their own case against the board and, in some cases, no dissent rights.
This is a very live concern. In the Delaware Chancery Court's 2013 decision In re Trados Inc., the venture-capital-controlled board of directors was only saved from liability by the fact that the common shares were worthless at the time of the impugned merger and, as such, the transaction was "fair." However, the case always affirmed the principle that, where common and preferred interests diverge, a director can breach her fiduciary duty by "by approving a sale which could be viewed as improperly favouring the interests of the preferred over those of the common shareholders."
Whether Canadian courts would view things this way is unknown. The Canadian Venture Capital Association isn't leaving things to chance: It has recently modified its precedent documents in response to the Trados decision, suggesting that drafters remove the authority of the board of directors to vote on "drag along" rights, which force certain shareholders to sell their shares in certain circumstances.
In addition, Trados is a Delaware decision – our corporate statutes, corporate common law and contract law are all similar to those of Delaware but also different in important ways. There are, certainly, other strange and surprising ways corporate and contract law can interact and create conflicts between preferred shareholders and common equity.
Thoughtful drafting can mitigate these problems but, ultimately, conflicts between common and preferred shareholders are an inevitable consequence of the capital structure of most private tech companies. In short, it's not always sunny in San Francisco. There may be no perfect capital structure, but, at least, with the preferred-common structure, it seems like the problems only lead to litigation when good technologies go bad.
Adrian Myers is a lawyer at Torkin Manes LLP.