Joshua G. Galante

In merger and acquisition (M&A) transactions, parties commonly include a post-closing mechanism to adjust the purchase price to accurately reflect the agreed value of the acquired asset. Many of these mechanisms are accounting-related and require specific calculations. While practitioners typically describe detailed methods for these calculations in the purchase agreement, disputes may still arise, making it crucial for the parties to include clear provisions on how such disputes should be resolved. In some cases, parties opt for arbitration, while in others, they choose to have accounting-related disputes handled by an expert. A recent Delaware Superior Court opinion emphasizes the importance of clarity and precision in drafting these dispute resolution provisions, particularly regarding the scope and authority of the decision-maker and the availability of judicial review. In Pazos v. AdaptHealth, plaintiff Cynthia Pazos, founder and former CEO of Diabetes Management and Supplies LLC, sold her company to the defendant, AdaptHealth LLC, an operator of a network of medical equipment companies providing products and services to outside-hospital patients. The membership interest purchase agreement (MIPA) included post-closing purchase price adjustment calculations, specifically to account for the closing working capital of the company. The MIPA also contained dispute resolution provisions for disagreements about the closing date statement, stating that if the parties failed to agree, any disputed amounts would be submitted to independent public accountants for determination. The accountant’s determination would be deemed final and binding, subject to review only in the case of a “manifest error.” Notably, the MIPA explicitly stated that the accountant would act as an expert, not an arbitrator. In this case, after the accountant made its determination, the plaintiff, dissatisfied with the result, filed a complaint in Delaware court, alleging that the accountant had committed several manifest errors. In response, AdaptHealth argued that the Federal Arbitration Act should apply to the court’s review, contending that the dispute resolution provision functioned as an arbitration clause. The court disagreed, clarifying the difference between arbitration and expert determination provisions. Using the “authority test,” the court concluded that the provision in question was an expert determination one because its scope was limited to resolving cost adjustment disputes. Additionally, the use of the term “expert” rather than “arbitrator” signaled the parties’ clear intent. Through this ruling, the court clarified that practitioners must be deliberate and cautious when drafting dispute resolution clauses, ensuring the parties’ intentions are explicitly reflected. Having established that the accountant’s role was to act as an expert and confirming the court’s limited oversight role based on the clear language of the MIPA, the court also examined the definition of “manifest error” in the context of expert determinations. The plaintiff objected to the accountant’s exclusion of certain receivables from the working capital calculation, arguing that these exclusions constituted manifest errors. The court disagreed, concluding that a manifest error would exist only where the expert made a plain and obvious error and the record demonstrated a strong reliance on that error. The court also determined that an expert’s decisions, such as which documents to credit or discredit, fall within that expert’s contracted-for authority. As such, the manifest-error standard sets a high bar for overturning an expert’s determination. This case serves as a reminder that precision in drafting dispute resolution provisions is critical in M&A transactions. Parties must clearly define the roles, scope and authority of the individuals resolving accounting-related disputes, whether they choose arbitration or expert determination. The failure to do so can be detrimental to one’s ability to bring a claim in court. Furthermore, practitioners should be aware of the high threshold for establishing “manifest error” in expert determinations, as courts are unlikely to intervene in decisions that fall within the expert’s contractual authority.

With 2023 off to a rocky start for entrepreneurs and startups due to rising interest rates, inflationary pressures and the collapse of highly recognized banks for venture-backed companies – such as Silicon Valley Bank (SVB), Signature Bank and other financial institutions with a greater appetite to do business with these types of riskier companies – the market saw both a pullback by venture capital firms, limiting follow-on equity rounds for the weaker companies in their portfolio as well as a sharp decline in the availability of venture debt. The simultaneous pullback in both the equity and debt markets for these early- and growth-stage companies has left many of these companies in a precarious position, focused on capital preservation and, in some cases, survival, with many ending up in a fire sale or shutdown mode. There was a great deal of uncertainty as to what the future held in terms of venture debt after the upheaval in the banking market. For the remainder of 2023 and beyond, it initially seemed unlikely that traditional banks, including those remaining banks that targeted the startup world, would be the source of venture debt due to the riskier nature of these loans (which generally would not meet their underwriting criteria) as well as more uncertainty and unpredictability in the growth prospects of many of these companies, given the instability in the financial markets for both debt and equity. However, recent trends suggest that there may be more banks than expected that have jumped in to fill the void, with HSBC and Stifel starting to offer new financing alternatives (both institutions picked up former SVB team members) and CIBC and First Citizens Bank (which acquired SVB) continuing to make and honor existing loans. It will be interesting to see how HSBC targets the market, as it recently launched a venture banking practice, but the growing consensus is that loans will start at $1 million post-Series A. To understand venture debt as it is today, one must understand its history. Venture debt became prominent in the 1970s and 1980s with the rise of SVB and similar lending institutions willing to accept more risk and do business with high-growth startups. Many of the great companies that we all know of today were, in part, the product of venture debt. Venture debt seemed to peak during what is known as the pre-dot-com era (mid/late 1990s). During this period, venture debt financing topped out at around $5 billion. This was until 2001 when events took place that led to the bursting of the dot-com bubble and the crash of the markets in the early 2000s. This crash led to many venture capital firms exiting the market and others becoming much more conservative and risk averse. Things again started to look up in the mid-2000s, but the market was again crushed by the crash of 2008. Much as in the 2001 crash, lenders became significantly more risk averse or they exited the market completely. Venture debt only works if there is venture capital (equity behind it), and much of the exit of venture debt in these prior financial crises was tied to the lack of new equity investment. As the market came back with a vengeance in recent years, lenders had again become more flexible in their lending habits, and the venture debt market grew tremendously. However, the rapidly rising interest rates, inflationary pressure, volatile public markets and other macroeconomic factors, including the collapse of SVB and other banks as noted above, that converged in late 2022 and early 2023 led many to speculate that venture debt markets would tighten significantly – and they did, in fact, do so for the first half of 2023. But there does seem to be a light at the end of the tunnel, although likely with more conservative terms and underwriting. What Is Venture Debt, and How Does It Work? What is venture debt? So, what is venture debt? At a high level, venture debt is similar to any other kind of debt. It is a loan from a bank or a nonbank lender to early-stage companies that have previously completed round(s) of venture capital equity funding. Most of the time, these companies have strong growth potential but little to no marketable collateral such as cash, real estate or liquid investments with which the lender can secure its obligations under the loan, making them risky candidates for conventional bank loans. When they lend, venture debt lenders, as opposed to conventional banks, focus more on a company’s growth potential and equity backing than its cash flow and profits. Additionally, venture debt can be attractive to early-stage companies, as it can be used as a complement to equity financing that will not dilute existing equity ownership or change management control in the company. Who are the lenders? Venture debt lenders and equity investors are very different. In a nutshell, equity investors, such as venture capital firms and high net worth individuals, infuse a certain amount of capital into a company in exchange for an equity ownership interest in the company. Equity investors hope to achieve a big return on their investment once the company matures and declares and issues dividends and/or there is a sale event, among other liquidity events. They usually get a preferred return of capital and perhaps an accruing dividend on that capital that is paid when and if there is a liquidity event, but they generally do not have a set timetable or the equivalent of a maturity date nor a guaranteed repayment obligation from the company as to either return of invested capital or a certain return on their investment. To the contrary, when venture debt lenders enter into a credit facility, the lender expects to be repaid every cent that is lent plus interest. This is no different from a residential mortgage company demanding that you repay your entire mortgage plus interest, but the venture debt lender does not have a lien on your residence as security for the loan. How does venture debt work? As an initial matter, before a venture debt lender agrees to lend to an early-stage company, the lender generally will assess the company’s business plan, financials and growth potential to determine whether they will proceed with a loan and, if so, how much funding they will provide. Because lenders in this space assume a greater risk when loaning to unproven companies, as compared to traditional loans to established companies, it goes without saying that lenders want to be protected and compensated accordingly. For example, venture debt normally follows a round of venture capital (e.g., equity or subordinated debt) funding as a form of support for the lender’s extension of credit. Instead of securing its obligations through the company’s assets as a traditional bank does, it instead uses the amount of venture capital funding previously supplied as a source of validation. This is in part due to the overall theory behind venture debt; lenders place significant value on their trusted relationships with the venture capitalists behind the companies, which are often clients of the lender. Not only does the equity funding provide comfort to the lender in the form of support for the borrower from its existing or new investors, but the available loan amount also is set based on the previous round of venture capital funding. Normally, loans are limited to 25% to 35% of the most recent round of equity funding and are relatively short term (one to three years). These venture debt loans typically have an interest rate higher than the traditional loans we would customarily think of, due in large part to the speculative nature of the business that is borrowing the funds and the need to compensate the lender for the additional risk. In addition to higher interest rates to compensate the lender for its risk, venture debt is usually coupled with warrants to purchase the borrower’s equity to provide additional upside for the lender, assuming the company achieves future success. The total value of warrants issued to a venture debt lender is between 5% and 20% of the principal loan amount. These warrants are usually a right to buy the last round of priced equity and generally have a term of one to 15 years. Finally, venture debt lenders aim to protect themselves with certain operating covenants in the loan agreement by including affirmative and negative covenants that place limits on the borrower’s activities. However, as compared to a more traditional asset-based loan, the number of covenants included may be minimal and limited to just a few financial covenants. These financial covenants normally lay out conditions that the borrower must fulfill or avoid to maintain the relationship with the lender. Financial covenants are normally limited to the borrower promising to maintain a positive growth rate and/or maintain a certain level of liquidity. Venture lenders also historically required that borrowers maintain 100% of their cash balances with the bank acting as a lender. When depositors became aware of SVB’s problems, they quickly tried to withdraw their funds, even if it put their loans in jeopardy. This was, in part, a major issue during the collapse of SVB. Therefore, newer venture debt models appear to be more flexible, with some lenders willing to limit the deposit requirement to a lower percentage of cash or a fixed amount tied to the loan balance to cover debt service for a period of time. Relevance in 2023 In the first half of 2023, venture debt deals declined a whopping 38% across the board, going from $20.07 billion in 2022 to only $6.34 billion in 2023. This most likely can be attributed to the failure of SVB and the lack of larger banks and venture debt funds stepping up to fill SVB’s void, rising interest rates, and uncertainty in the markets. However, more recently, we have seen alternative lenders and other banks step in to try to fill this void. In the meantime, only time will tell how the venture debt market will react to the current macroeconomic environment.

Businesses operating within the U.S. market have been facing a growing list of challenges. Rapidly rising interest rates, reduced access to equity investment and debt facilities, and continuing supply chain issues, as well as the lingering effects of the COVID-19 pandemic, have forced many businesses to rethink their operations and reevaluate their financial models. This market volatility presents a unique set of challenges for companies that either wish to sell all or part of their business or otherwise wish to expand their operations through the acquisition of another company. Any business considering a merger, divestiture or acquisition (M&A) – from either the buy or sell side – may consider utilizing an earnout provision. Earnout provisions provide for a portion of the purchase price to be paid in future installments based on the performance of the acquired business after the closing of the transaction. Typically, payments are conditional on the acquired business achieving certain agreed-upon metrics, such as sales, revenue or gross profit levels. Often earnouts operate on a sliding scale within a minimum and maximum range, where the payment amount within this range increases based on a formula as the agreed-upon metrics are met or exceeded. This mechanism helps align the interests and valuation expectations of buyers and sellers and reduces the risk of overpricing or undervaluing the acquired company. But how does the current market volatility impact the way an earnout provision should be structured? This article will provide an overview of the increased use and scrutiny of earnout provisions in M&A deals during a down or volatile market. It considers how economic macro conditions impact the way earnout provisions should be drafted in M&A deals from both the buyer and seller perspectives. Advantages and Challenges of Using Earnouts One of the primary challenges of using earnouts in M&A deals is the uncertainty of future performance. The COVID-19 pandemic and current economic policy to address the inflationary pressure that has arisen as the world has emerged from this crisis have created unique challenges for businesses, and these have led to an uncertain economic climate, which makes predicting future financial outcomes of a target company particularly challenging. In this situation, determining the appropriate earnout formula or milestones can be difficult. Earnouts can provide a benefit to a buyer by delaying payment of a portion of the purchase price and ultimately reducing risk by tethering the purchase price to the performance of the newly acquired business. Utilizing an earnout may also be advantageous to a buyer during a bidding process – allowing a potential buyer to present a larger possible purchase price, while still minimizing risk around a target’s earning potential. The use of earnouts comes with its own challenges, however. Earnouts represent uncertainty in the final purchase price and risk to the seller. How a particular business will fare after a sale will depend on factors both inside and outside the control of management. An economic downturn may negatively impact at least the short-term ability to maximize the earning potential of a newly purchased business. Similarly, the buyer and the seller may have conflicting views regarding how the acquired business should be operated. An earnout is likely to cause the seller to be more focused on short-term growth, while the buyer may be more invested in the long-term success of the company. In the event an earnout threshold is met, buyers may have to secure additional sources of financing to pay the earnout amount, which may be more costly than anticipated. Even under good market conditions, earnouts require careful drafting, but a down or volatile market exacerbates these concerns. Sellers will always want the agreement to include protections regarding the ability to freely operate the business without interference from the buyer or changes with which they may disagree, such as changes in the management team or key employees, the incurrence of additional costs they deem unnecessary, or imposition of additional overhead on the business. Sellers may also be concerned about matters that are specific to the buyer, such as changes in the buyer’s business that could impact their earnout, including additional acquisitions; restrictions on a buyer’s business that limit customer growth, such as industry verticals in which they cannot pursue new business because of noncompetes; requirements to focus on less-profitable business lines due to synergy issues with the buyer;  a change in control of the buyer or a material adverse change in the buyer’s business unrelated to the target business. Buyers, on the other hand, want the ability to integrate the newly acquired business into their overall business and to have the seller’s operations conform to other parts of their business as well as potentially to either impose potential short-term cost-cutting measures on the business or require additional investments that could hamper or distract from achieving the earnout milestones. Therefore, buyers resist controls that might tie their hands or require specific actions on their part. They generally will not want any obligation to cooperate to maximize earnout potential or have any fiduciary-type obligations to the seller. As a general rule, a buyer will want minimal controls on its ability to operate the business and, at most, an obligation to act in good faith so as not to interfere with such operations in a manner intended to materially and adversely impact a seller’s ability to achieve an earnout. These covenants become very complicated and require significant thought and analysis. Earnout Trends From the 2022 Financial Year The 2023 SRS Acquiom M&A Deal Terms Study1 provides a useful overview of how earnouts are being used under current market conditions based on data trends observed throughout the preceding year. In 2022, approximately 21% of non-life science deals2 included an earnout provision. This represents a somewhat significant increase from the 2021 period, which had 17% of M&A deals use an earnout. Overall, this figure has been increasing since 2018 (a year in which we saw the year close with the worst stock market declines and volatility since the financial crisis of 2008), which saw a low of 13% of deals using earnouts but is comparable to the 2017 figure of 23%. Of the 21% of 2022 deals that included earnouts, 42% of these had a single trigger event, while 58% had multiple trigger events. Of these trigger events, revenue-based triggers were the most significant, representing 61% of the total deals. Trigger events relating to hitting certain earnings or EBITDA targets represented 23%, while 22% of deals used other forms of measurement (including such things as unit sales, product launches or divestiture of stocks). In terms of earnout numbers as a percentage of the overall deal size, the median earnout potential as a percentage of the closing payment3 remained relatively steady, at 31%, compared with the 30% figure from the 2021 period. Meanwhile, earnout length had a median period of 24 months, with 30% of earnouts being one year or less and 85% of earnouts having a period of three years or under. The use of certain earnout covenants was also considered by the SRS Acquiom study. Covenants to run the business in accordance with the seller’s past practices were included in only 23% of all earnout provisions surveyed. A mere 1% of earnout provisions included language requiring the business to maximize earnout payments. Earnout acceleration upon change of control was implemented in 30% of all deals included in the study. Finally, 73% of earnout provisions allowed the buyer to offset indemnity claims against future earnout payments. Specific language disclaiming that earnouts are not considered securities was increasingly used in the 2022 period; approximately 45% of all deals included such language, up significantly from 30% in the 2021 period. Finally, 19% of earnouts specifically disclaimed a fiduciary relationship between the parties. Use of Earnouts for Bridging Valuation Differences Earnouts can be particularly useful when there is a valuation gap between a buyer and seller, a situation that becomes more prevalent when a market quickly changes direction, as we have seen over the past 12 months. By agreeing to an earnout, both parties can align their interests and work together to achieve specific financial metrics. In this scenario, an earnout can act as a bridge between the two parties, providing the seller with the potential to receive additional payment and the buyer with the ability to spread the acquisition cost over time and not overpay if the targets are not achieved. Additionally, where a target company has a short operating history, earnouts may be a useful tool for sellers to increase their valuation price. Down-Market Controls To Negotiate in Earnout Provisions Be specific with performance metrics. Uncertainty in the market has caused both buyers and sellers to seek more control over their exposure to performance metrics. For sellers, this often materializes as heightened concern over whether the metric is practicably achievable under current market conditions and a push for more conservative milestones, as failure to reach the metric results in a lower purchase price, often leading to seller’s remorse as the seller receives less than it thought the business was worth. Meanwhile, buyers will typically seek to limit the risk of overpaying for the target company if the performance metrics are not achieved or only partially achieved. The buyer will still be pushing for reasonable growth targets that may be unpalatable to the seller. In negotiating targets that are reasonably acceptable to both sides, parties should draft the earnout provisions with specificity, including resolving issues of ambiguity with respect to accounting principles, overhead costs, intercompany charges and other factors that could impact the measurements in a way that varies from historical seller practices. While these issues are common to earnouts in any situation, whether or not it is a down market, defining the metrics is harder in a volatile market, where there are at play macroeconomic factors, such as inflation, increasing interest rates and supply chain issues that increase costs and make it harder to project results for the near term. Consider the length of the earnout period. The macro conditions of the economy can have a significant impact on performance metrics. During a down market, it may be more challenging for a newly acquired company to meet financial metrics that would have been more achievable in a steady market. To address these concerns, parties should consider provisions that mitigate the impact of macroeconomic conditions. This includes the use of measurement periods that could be longer than those in typical earnout provisions, which would allow a target company more time to achieve specific financial metrics. Consider “catch-up” or proration clauses. Ambiguity in a down market primarily concerns uncertainty about predicting future performance. Rather than draft an earnout provision to be “all or nothing,” parties should consider a sliding scale of payments. Alternatively, “catch-up” earnout provisions give sellers the right to collect at least a partial earnout payment if an acquired company fails to meet a specified target in one year but makes up the deficit in a subsequent year. Takeaway The use and scrutiny of earnout provisions during a down market have become increasingly common due to the uncertain economic climate. Despite the challenges associated with using earnouts and the need for careful drafting of these provisions, earnouts are still a useful tool for bridging valuation gaps and aligning interests between the buyer and seller. 1 SRS Acquiom Inc., M&A Deal Terms Study (2023), available at: https://info.srsacquiom.com/2023-srs-acquiom-deal-terms-study. 2 Earnouts are considered the industry standard in life-science deals and, as such, tend to skew overall figures, so such deals were excluded from the study. 3 Calculated as the sum of potential earnout payments over the amount paid at closing, including escrowed amounts.

One of the most important yet overlooked aspects of any commercial or corporate transaction involves confidentiality obligations. Often, parties gloss over the scope of the covenants, treat them as boilerplate using precedent without thinking through the details, such as what information needs to be protected in the particular transaction at hand, who should be subject to the restrictions, what limitations need to be imposed on the use of any disclosed information and sometimes, forget to include the covenant or enter into a separate confidentiality agreement altogether. This is especially true for venture capital, private equity and related fundraising transactions where companies may have numerous stockholders with varying or conflicting interests. For expediency and cost savings, early-stage venture capital deals typically involve the use of standardized forms, such as the Series A financing documents published by the National Venture Capital Association (NVCA). The NVCA forms include typical information and inspection rights which give at least significant investors broad-based access to confidential information regarding the company. Therefore, the NVCA forms do include a confidentiality provision protecting information received by investors in this context. Having said this, lawyers should still review these documents carefully and consider the specifics of the company and transaction, for example, the types of investors involved (e.g., funds vs. strategic investors), as there may be different sensitivities based on the nature of the investor. However, not all early-stage venture capital transactions use the NVCA forms, and many later-stage venture and private equity deals use bespoke sets of agreements prepared by individual law firms. And, even when precedential forms have been supposedly fine-tuned over time, they may not have adequate provisions for confidentiality in the context of the specific transaction. Further, there may be certain investors not covered by the provisions of the NVCA forms or other primary transaction documents (either because they don’t meet the threshold set forth in the documents to qualify for information rights in such documents or they are investing through another type of instrument, such as a convertible note). In such cases, it is customary for such investors to request information rights, rights to inspect company records and access to management in a side letter. It is important to make sure that side letter rights also are subject to adequate confidentiality and non-use restrictions. In addition to contractual rights, Delaware corporations need to keep in mind that under Section 220 of the Delaware General Corporation Law (the DGCL), stockholders of a Delaware corporation have the statutory right to access corporate books and records for a “proper purpose.” The term “proper purpose” is not expressly defined in the DGCL, but cases involving such demands generally arise in the context of allegations that a stockholder desires to value its interest in the company or has a credible basis to believe there is wrongdoing or mismanagement at the company or a breach of fiduciary duties by officers or directors. This was seen in a recent Delaware case1 (Rivest v. Hauppauge Digit., Inc.) in which the court permitted the disclosure of nonpublic information to a stockholder of a public corporation who exercised his Section 220 rights and did not afford confidential treatment to the corporation’s books and records. This case involved an individual plaintiff seeking to value his shares in a corporation that went “dark” for a number of years, did not make any public disclosures and ignored the requests of the plaintiff for financial and other information concerning his investment. The court stated that there is no presumption of confidentiality as it relates to a Section 220 demand, and the relevant facts and circumstances at hand would be weighed in determining whether or not to afford confidential treatment. The court went through a thorough and detailed analysis of the harm that could be imposed on the corporation for not affording confidential treatment of the corporation’s financial information, including that such information could be used by competitors of the corporation and could put the corporation out of business. On the contrary, the court also detailed the benefits of allowing the plaintiff to obtain such financial information without confidential treatment, including that the plaintiff was seeking basic financial information to value his shares, which falls within the criteria for a proper purpose for a Section 220 demand. In determining not to afford confidential treatment to the disclosed information and permitting the plaintiff to inspect the corporation’s financial records, the court stated that “Rivest has established a significant interest in obtaining financial statements for closed periods free of any confidentiality restriction [and] [t]he Company has not made a showing sufficient to outweigh Rivest’s interest and warrant a two-year confidentiality restriction.” While the company at issue in Rivest v. Hauppauge Digit., Inc. was a public company, in a recent transaction in which we were involved, a venture capital-backed company was pursuing a sale transaction and had a strategic investor who was potentially interested in acquiring the company. The company received a written request from such stockholder, purportedly in the context of wanting to monitor its investment. The request (which was not a formal Section 220 demand) was for various information pursuant to such stockholder’s information rights in an investor rights agreement. The information requested was highly sensitive because of the ongoing negotiations of the sale, certain prior communications with such stockholder indicating such stockholder was not necessarily supportive of the sale, and the fact that this stockholder had a commercial relationship with the company. In that matter, the investor was subject to adequate contractual confidentiality and non-use restrictions on the information, but in the absence of such limitations, this could have been highly problematic because disclosure could have violated agreements with the potential acquirers and could have led to leaks of information on a highly confidential transaction and potentially disrupted the closing of the sale. The absence of such restrictions could have allowed the recipient to share the information or use the information for a purpose other than monitoring its investment. If this stockholder had sought to make a Section 220 demand, the existence of the confidentiality provision in the agreement would likely have led a court to provide confidential treatment to any disclosed information – however, in future transactions, we have already made a note to make sure we explicitly extend these provisions to any demand, not just the information provided under the investment documents. Statutory information rights can be waived, and the investor rights agreement published by the NVCA does include an optional provision for the waiver of statutory information rights, though we don’t typically see investors agreeing to such a provision. Therefore, when statutory information rights are intact and not expressly waived, any contractual confidentiality obligation needs to take into account not only information provided pursuant to contractual information rights but also information provided in other contexts, such as statutory information rights. Further, it is critical, especially in private companies, to include strong confidentiality obligations in investment documents whether or not such documents provide stockholders with explicit rights to disclosure of, or access to, confidential and proprietary information, in order to protect such information from unwanted use and/or disclosure beyond the particular stockholder and for proper purposes. Such agreements should clearly define the types of information protected, the defined purposes for which such information may be used and the parties with whom such information may be shared (e.g., a venture capital or private equity fund may request the right to share certain limited information with its partners for valid reporting purposes). In the absence of such pre-existing agreement at the time of the demand (often made without court intervention), companies should also keep in mind that it is customary to ask for a confidentiality agreement before sharing such information. 1See Rivest v. Hauppauge Digit., Inc., 2022 WL 3973101, at * 1 (Del. Ch. Sept. 1, 2022).

Angel investors, venture capital and private equity funds often seek to secure some presence, formal or informal, within the board meetings of the corporations in which they invest. Such representation and participation in corporate governance provide potential benefits to both the investor and the portfolio corporation. The corporation can benefit from having experienced investors participate and provide guidance in board meetings and beyond. While some corporations may be wary of offering such investors a formal seat on the board of directors, one option commonly employed is to grant investors or their representatives rights as “board observers.” Such persons may observe and even participate, usually in some limited fashion, in meetings of the board of directors. They generally get rights to attend meetings and obtain all materials provided to formal members of the board, but in a non-voting capacity. Granting such rights, however, introduces a number of unique issues and subtle potential pitfalls that both the corporation1 and the investor should carefully assess. Little caselaw or statutory guidance exists on the rights and obligations of board observers. Corporations and investors, each seeking to protect themselves, should therefore ensure that they expressly delineate those rights and obligations in advance via a detailed board observer agreement executed by both the corporation and the observer. Some of the key considerations to address in such an agreement, and related issues, are discussed below. Fiduciary Duties Corporate law generally does not impose fiduciary duties on board observers. Such fiduciary duties typically arise where one party manages an asset or group of assets for another, as a result of which the law will accordingly impose on the manager certain duties of loyalty and care with respect to the beneficiary. Directors, officers and managers of the corporation, having been charged with the duty to manage the assets of the corporation, are deemed fiduciaries with respect to the stockholders. But since board observers, by contrast, will typically have no formal responsibility for managing the corporation’s assets, they will typically not be deemed to owe the corporation any fiduciary duty. From the corporation’s perspective, the lack of fiduciary duties can lead to conflicts of interest, especially with strategic investors who may be in the same industry or business as the corporation. Such conflicts would not be addressed by an overriding duty of loyalty or duty not to act in a self-interested manner. Where an investor designates a representative to sit on the board, either formally or informally, that director could be said to be wearing two hats, one as a representative of the investor and one as a fiduciary to the corporation. In fact, that representative may even owe fiduciary duties to the investor who designated such person to sit on the board. As a formal board member, the duty of loyalty would protect the corporation from such conflicts. Therefore, on the one hand, companies often attempt to include language in board observer agreements that requires the board observer to act as if it were subject to fiduciary duties. On the other hand, investors often want the opposite, to expressly state that the board observer is not a fiduciary of the corporation. In fact, often, an investor will prefer an observer seat specifically because they are concerned about conflicts of interest created by such fiduciary obligations. The investor is interested in access to information and a window into its investment but doesn’t necessarily feel the need for a formal board seat that would give it the power to direct the affairs of the corporation through a vote on the board. Regardless of whether the board observer agreement expressly addresses fiduciary obligations, the agreement should both define the scope of the board observer’s rights to participation and access to information as well as seek to protect the corporation by imposing express limitations on such rights. For instance, the agreement should make clear that the observer is not entitled to vote at board meetings, may not veto any decision or action taken or being considered by management and may be excluded from receiving certain information or attending portions of meetings, as more fully discussed below. It may even subject the observer to additional restrictions on the use and disclosure of information that are not necessary for voting members of the board. The agreement may also specify the conditions upon which the board observer’s rights may sunset, for instance, if the investor who has the right to designate the observer does not continue to hold a specified amount of stock or by or before an identified end date. Confidentiality and Privilege As a non-member of the board and a representative of a third party, the board observer’s mere presence in the board meeting may compromise the confidentiality of information shared or discussed in the meeting. The observer’s presence may also destroy the privilege that attaches to a meeting between the corporation’s board and the corporation’s attorneys. Special care should accordingly be taken to address these issues in the board observer agreement. Courts considering the issue have reached varying conclusions on whether the provision of confidential or privileged information to a board observer waives the attorney/client privilege with respect to such information. In Finjan, Inc. v. SonicWall, Inc., a decision issued by the United States District Court for the Northern District of California in 2020, the Court found that a corporation’s disclosure to a board observer of information otherwise protected by the attorney/client privilege constituted a waiver of the privilege with respect to that information. By contrast, the United States District Court for the Eastern District of North Carolina held the exact opposite in a 2005 case, PharmaNetics, Inc. v. Aventis Pharmaceuticals, Inc. Corporations and investors should attempt to address this uncertainty upfront through their board observer agreement. The agreement should expressly define “Confidential Information” and impose unambiguous obligations on the observer to protect and maintain the confidentiality of such information and to not use the information for any purpose other than for monitoring the relevant investor’s investment in the corporation. In many situations, it should also contain appropriate limitations upon the sharing of competitively sensitive information. The agreement should also make clear that all such information is proprietary to the corporation and may contain trade secrets, the disclosure of which would harm the corporation. The restrictions imposed should apply broadly to all those parties with whom the observer is authorized to share information obtained from the corporation. The board observer agreement may also expressly provide the corporation the right to withhold certain proprietary information, especially if it could jeopardize trade secret protection for such information. The board observer agreement should also give the corporation the tools necessary to protect the corporation’s attorney/client privilege by expressly stating the corporation’s right to exclude the observer from any meetings or discussions with counsel where the observer’s presence might constitute a waiver of privilege. The corporation’s right to exclude the observer should also extend to situations in which matters being discussed may give rise to a potential conflict of interest. Of course, even when an agreement allows the corporation to exclude the observer for privilege reasons, the corporation must remain vigilant and actually exercise such right at appropriate times, or the privilege could be inadvertently waived. Conclusion Though the presence of board observers is fairly common in privately held corporations, corporations should think twice before liberally agreeing to allow any investor to appoint an observer, as their access to information and participation in a corporation’s board meetings raises a number of potentially significant issues for both the corporation and the investor. Given the relative lack of statutory guidance or caselaw governing the rights and obligations of these observers, both sides should ensure that they protect themselves in advance through the careful drafting and execution of a comprehensive board observer agreement. Stradley Ronon has a deep bench of experienced attorneys who regularly draft board observer agreements for a variety of corporate and investor clients. We are well-prepared to assist you with any legal needs you may have in this area or any related area, including those involving startup investments, compliance and governance. 1 Though this article focuses on observer rights with respect to corporations, observer rights can also be granted in entities that use other forms if they have boards or functionally similar governing bodies.

In a recent M&A transaction, a nuanced issue regarding the exculpation of directors under the Delaware General Corporation Law (DGCL) arose in the context of a potentially conflicted director serving on the board of a company considering a sale transaction. The company was an early-stage Delaware corporation that had completed multiple rounds of equity financing, the most recent of which was led by a strategic investor in the same industry as the company. At the time of its investment, the strategic investor negotiated for the right to designate one director to the company’s board. Due to the strategic investor’s potential interest in acquiring the company, when the company began considering acquisition offers, the strategic investor’s designated director had at least the appearance of a conflict of interest. In considering the potentially conflicted director’s obligations in the context of the board’s deliberations, counsel for the strategic investor incorrectly assumed that the exculpation language in the company’s certificate of incorporation, which is explicitly permitted (and limited) by Section 102(b)(7) of the DGCL1, amounted to a waiver of all fiduciary duties by the company.2 As Section 102(b)(7) makes clear, however, no such provision may exculpate a director for any breach of the duty of loyalty. Under the counsel’s mistaken interpretation, the director would have been free to share information he received in his capacity as a director with the strategic investor for whom he worked, potentially to the detriment of the company. As noted in prior Delaware case law, while it is possible to cleanse an interested party transaction under Delaware law, a director cannot disclose information to the appointing stockholder when such director is wearing two hats, i.e., if the disclosure could cause harm to the company to which such director owes a duty of loyalty.3 This is definitely a conundrum for directors appointed by private equity firms or other purely financial investors in many situations, but can be even more of a challenge for directors designated by strategic investors, who often have interests that are not solely focused on maximizing the economic value of their investment in a manner that is aligned with other stockholders. While the duty of loyalty issue was ultimately resolved between counsel, the scenario highlighted an interesting secondary issue: whether Delaware law would have required the same outcome if the target company had been a Delaware LLC. As practitioners know, while a corporation is a creature of statute, LLCs are generally creatures of contract. There are also important differences between the DGCL and the Delaware Limited Liability Company Act, particularly with respect to fiduciary duties. As the Delaware Court of Chancery noted in the recent Manti case4, and as is well established in Delaware law: “Waiver of fiduciary duty is a permitted feature of the LLC form.” The DGCL allows corporations to eliminate director liability for breaches of the duty of care, as described in Section 102(b)(7), and to renounce corporate opportunities, but the DGCL does not expressly authorize a contractual waiver of fiduciary duties or of claims to enforce such duties. By contrast, the Delaware Limited Liability Company Act has broad enabling provisions that allow for private ordering, including the modification or elimination of all fiduciary duties. The Manti case hinged on a purported contractual waiver of corporate directors’ fiduciary duties, but due to the court’s rejection of the waiver interpretation, the court did not ultimately rule on whether such a contractual waiver would be permissible in the corporate context. Exculpation from financial liability under Delaware corporate law has express limits and does not amount to the type of broad waiver that can be contracted for in LLCs. While there are many reasons that venture capital investors, in particular, prefer the use of Delaware corporations for their investments, when structuring investments generally, in addition to tax and other factors, consideration should be given to whether a corporation or LLC is the best vehicle in light of potential conflicts of interest that may arise in connection with exits and future financing arrangements. From the company’s perspective, these types of conflicts should be given serious consideration when deciding upon the composition of the board of directors, especially as it relates to strategic investors’ access to all of the information that would normally be shared with a board. Relatedly, as previously noted in Business Vantage Point, recently enacted amendments to the DGCL will likewise extend the right of a corporation to exculpate officers in certain situations, but it is clear that this expansion relates solely to the duty of care, as the prior version of the statute was also so limited with respect to directors. The expanded exculpation right does not apply to the duty of loyalty implicated in most conflict of interest cases involving a director appointed by, and in many cases employed as an officer or manager of, a stockholder who may be interested in a sale or other significant transaction. 1 DGCL Section 102(b)(7): Section 102: Contents of certificate of incorporation. … (b) In addition to the matters required to be set forth in the certificate of incorporation by subsection (a) of this section, the certificate of incorporation may also contain any or all of the following matters: … (7) A provision eliminating or limiting the personal liability of a director or officer to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director or officer, provided that such provision shall not eliminate or limit the liability of: (i) A director or officer for any breach of the director’s or officer’s duty of loyalty to the corporation or its stockholders; (ii) A director or officer for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law; (iii) A director under § 174 of this title; (iv) A director or officer for any transaction from which the director or officer derived an improper personal benefit; or (v) An officer in any action by or in the right of the corporation. No such provision shall eliminate or limit the liability of a director or officer for any act or omission occurring prior to the date when such provision becomes effective. An amendment, repeal or elimination of such a provision shall not affect its application with respect to an act or omission by a director or officer occurring before such amendment, repeal or elimination unless the provision provides otherwise at the time of such act or omission. All references in this paragraph (b)(7) to a director shall also be deemed to refer to such other person or persons, if any, who, pursuant to a provision of the certificate of incorporation in accordance with § 141(a) of this title, exercise or perform any of the powers or duties otherwise conferred or imposed upon the board of directors by this title. All references in this paragraph (b)(7) to an officer shall mean only a person who at the time of an act or omission as to which liability is asserted is deemed to have consented to service by the delivery of process to the registered agent of the corporation pursuant to § 3114(b) of Title 10 (for purposes of this sentence only, treating residents of this State as if they were nonresidents to apply § 3114(b) of Title 10 to this sentence). 2 The language in question originated from the National Venture Capital Association’s model Certificate of Incorporation, Article Ninth, which is available here. 3 Also worth noting is that the strategic investor had contractual information rights, as is typical for major investors in venture capital equity rounds. Information provided by the company to the investor pursuant to these contractual rights would not be subject to the same limitations based on fiduciary duties, although it would remain subject to applicable contractual confidentiality obligations. Further, all stockholders of Delaware corporations have the right to demand certain books and records pursuant to Section 220 of the DGCL, and other recent Delaware caselaw suggests that nonpublic company information furnished pursuant to a Section 220 request may not always be protected by confidentiality obligations. 4 Manti Holdings, LLC v. The Carlyle Group Inc., C.A. No. 2020-0657-SG (Del. Ch. Feb. 14, 2022).