Startups frequently have directors who wear multiple hats, serving simultaneously as a founder, investor, officer, employee, advisor, lender, or owner of another business. Those overlapping relationships can lead to transactions in which a director has a financial or other material interest that could conflict with the company’s interests in the transaction.
While interested director transactions are not prohibited, care must be taken when evaluating such a transaction and when deciding whether to proceed with such transaction. For a Delaware corporation, DGCL Section 144 provides an important statutory safe harbor for these transactions. Even with this safe harbor, startups should not treat compliance with the statute as merely a box-checking exercise. A well-documented, independent process can be just as important as the ultimate vote.
The following is a non-exhaustive checklist to help a startup and its board navigate an interested director transaction.
Identify the conflict early. Determine whether any director has a direct or indirect financial, personal, or other material relationship with a party to the proposed transaction.
Disclose the conflict to the board. The interested director(s) should disclose the material facts concerning the relationship and the proposed transaction before the board considers approval.
Put the material terms before the board. The board should have access to the material terms of the transaction, including the consideration to be paid or received, obligations of each party, and any other terms that could affect the company's decision.
Consider whether the transaction is fair to the company. The board should evaluate whether the transaction is in the company's best interests and, where appropriate, whether the terms are comparable to what the company could obtain from an independent third party.
When appropriate, recuse the interested director. Section 144 does not automatically invalidate a transaction merely because an interested director participates in the board's consideration or approval. Nevertheless, having the interested director recuse themselves from deliberations and voting is generally cleaner and helps demonstrate that the disinterested director(s) exercised independent judgment.
Consider alternative transactions. The board should consider whether the company has realistic alternatives, including obtaining competing proposals, soliciting third-party bids, or negotiating with unrelated counterparties. The purpose is not necessarily to run a formal auction, but to give the board a reasonable basis for concluding that the proposed transaction is in the company's best interests.
Use disinterested director approval where possible. Delaware law provides a statutory path for cleansing certain interested director transactions through approval by disinterested directors. Depending on the circumstances, approval can be effective even where the disinterested directors constitute less than a quorum, provided the applicable statutory requirements are satisfied.
Consider stockholder approval. For transactions that do not involve a controlling stockholder, an informed, uncoerced approval by disinterested stockholders may provide an additional statutory path under Section 144.
Give directors adequate information and time. Directors should receive the material information necessary to evaluate the transaction and, for significant transactions, sufficient time to review that information and ask questions before voting.
Consider independent advice. For material transactions, the board should consider whether it would benefit from independent legal, financial, valuation, tax, or other professional advice. This can be particularly important where the transaction involves a valuation, related-party financing, IP rights, or significant consideration.
Check the company's governing documents. Review the certificate of incorporation, bylaws, stockholder agreements, investor rights agreements, voting agreements. Contractual requirements can impose additional approval obligations beyond Delaware statutory requirements.
Check financing and investor requirements. Venture-backed companies should determine whether their financing documents require approval from particular directors, preferred stockholders, or investors before entering into interested party transactions.
Build a contemporaneous record. The board minutes, or written consent, should document the conflict disclosure, the material terms considered, the information provided to directors, any recusal, the alternatives considered, questions raised, advice received, and the basis for the board's decision.
As outlined above, care should be given and decisions supported with a clear record to help ensure statutory compliance and alignment of the company’s governance documents. Seeking third party counsel is one way to help provide backing that adequate care and consideration was given. If you have questions about an interested party transaction, you can reach us at hello@archetypelegal.com
Disclaimer: This post discusses a general legal topic, is intended to serve as informational only, and may not reflect the most current legal trends in your jurisdiction. This informational post is not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Archetype Legal PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this post.
