Recent events are showing that syndicates are sometimes challenged to act quickly, methodically, consensually and effectively when the portfolio company is showing signs of poor performance and the possibility of a sub-venture return.
There can be disagreement amongst the directors as to the prospects of the portfolio company, uncertainty about the best approach to be taken in the circumstances that could include hesitation about leadership in the syndicate group or senior managers.
Syndicate members may be reluctant to rock the boat or engage in open conflict especially if they are concerned about preserving relationships in other portfolio companies. Paralysis ensues. At the opposite extreme, venture fund appointed directors act alone to make deals with purchasers and intermediaries. The results can be chaotic.
As we have seen, the common economic interest between venture investors existing at the A round can be eroded by the particular circumstances affecting each investor. As time passes to a critical decision point, one may be seeking to show even a modest return as part of a new fund raising cycle while another is ready to re-invest in order to delay the portfolio liquidity event to a future where higher valuations are expected.
For a variety of reasons, then, informal communication between the investor group, outside of or in the context of Board meetings, can be time-consuming and ultimately un-productive. Unfortunately, once a portfolio company is in distress the implementation of a procedure to formalize inter-syndicate relations can be difficult.
Why not plan ahead in the same manner as you pack a life jacket on your boat or carry a spare inner tube or two for your carbon fibre road bike? Nobody’s saying that emergencies are inevitable –you just want to be ready if it happens. In that spirit, investors are invited to consider the inclusion of language in a shareholders’ agreement which contemplates the establishment of a Special Situations Committee (“SSC”) in the same manner as the audit committee and the compensation committee.
Although the concept is subject to a variety of expressions and articulations the following is a start:
The SSC would be formed and begin the exercise of its functions on two triggering events: (i) Distress (as prospectively defined below) and (ii) direction of the Board.
Membership would be determined at the time of the Triggering Event by appointment of the two directors appointed by the two largest shareholders of the portfolio company. In the alternative, membership could be a function of percentage held of the class of share issued in the last financing. For example, two directors appointed by shareholders holding not less than 60% of the last issued class.
The members of the SSC could be permitted to delegate their appointment to the CEO or a director representing another shareholder;
The SSC would have the power to:
- Invite the CEO or the CFO to sit in an advisory capacity to the SSC;
- Engage financial advisers, appraisers, business valuators and legal counsel;
- Negotiate and execute letters of intent for the sale of the portfolio company’s assets or all of its shares;
- Make binding recommendations to the Board with respect to the engagement or dismissal of senior management including the CEO;
- Make binding recommendations to the Board in respect of the acceptance of letters of intent for the sale of the portfolio company’s assets or all of its shares.
There is a technical discussion to be had about the power of a committee of the Board to gain exclusive jurisdiction and authority in respect of the types of matters listed above which could be the subject of another article. Suffice it to say that challenges to the legality of a decision of the SSC to sell the portfolio Company would be difficult if the shareholders agreed in advance in the context of a unanimous shareholders’ agreement to abide in that decision.
Quite clearly, if Distress is a triggering event for the empowerment of the SSC, its definition becomes of vital importance. One possible definition is as the occurrence of any one of the following:
- Service of a claim of intellectual property infringement which in the opinion of an independent adviser (which could be the corporation’s counsel, its audit firm or a combination thereof) raises material issues with respect to the value of the portfolio company’s business;
- Failure to meet sales forecasts in three successive quarters;
- Resignation or dismissal of a member of the senior management team such as the CEO, CTO or VP Sales;
- Resignation of a director for reasons of avoidance of personal liability arising from the portfolio company’s failure to meet its obligations to third parties;
- Passage of a period of three months following completion of an internal convertible debenture round of financing without an ensuing investment by an external investor in an equity round;
- Insolvency (defined as being unable to meet liabilities as they come due);
- Notification from a venture shareholder that it is unable or unwilling to fund its pro rata in an investment round;
- Wind-up or bankruptcy of an institutional shareholder; and
- Dismissal of a venture shareholder representative on the Board by his/her general partner.
For some, setting up a committee in advance of hard times makes no sense. This may be true if a portfolio company’s shareholder agreement already contemplates the creation of an executive committee with powers similar to the proposed SSC. Experience dictates, however, that the executive committees are not routinely established in venture backed companies.
Also, to be clear, it is not contemplated that the SSC would operate in parallel to the Board as an executive committee might but would only exercise its functions on the occurrence of Distress or upon the direction of the Board.
The negotiation and articulation of the share provisions, shareholders’ agreement and purchase agreement has become a familiar part of the investment process for venture investors and their advisors. It is at that time that the expectations of all of the parties are established or re-set. Provisions dealing with the impact of unknown events on subsequent liquidity naturally inspire caution. As well, it is not usual for investors at the initial stages to contemplate an eventual disinterest in the portfolio company. The events of the last few years have shown, however, that some investors can sustain an unexpected marathon better than others. It perhaps comes down to accepting the principle that those that have the most to lose at the time of difficulty should be permitted to make the hard decisions.
The foregoing constitutes a proposal of a general nature for dealing in advance with a problem that recent history is showing us may occur again. The details of the drafting will obviously differ from situation to situation but, as stated above, why not be prepared?