Last week, I blogged about Vice Chancellor Laster’s opinion in Seavitt v. N-Able, (Del. Ch.; 7/24). One of the more interesting aspects of his opinion addressed the permissibility of language in N-Able’s certificate of incorporation making certain of its provisions “subject to” the terms of the stockholders’ agreement that was at issue in the case. The defendants argued that this was permitted by Section 102(d) of the DGCL, which provides that:
Any provision of the certificate of incorporation may be made dependent upon facts ascertainable outside such instrument, provided that the manner in which such facts shall operate upon the provision is clearly and explicitly set forth therein. The term “facts,” as used in this subsection, includes, but is not limited to, the occurrence of any event, including a determination or action by any person or body, including the corporation.
Vice Chancellor Laster disagreed that the “ascertainable facts” language of Section 102(d) was broad enough to permit the incorporation by reference of a stockholders’ agreement into a corporate charter. This Paul Weiss memo summarizes the key points underlying his reasoning:
– “Facts ascertainable” are not “provisions ascertainable.” The court reasoned that Section 102(d)’s reference to “facts” ascertainable outside a charter does not include outside “provisions” or other incorporation by reference of a broad, substantive nature. According to the court, “facts ascertainable” refers to specific inputs and are not a vehicle for introducing substantive provisions. According to the court, the examples of “facts” given in the statute (i.e., “the occurrence of any event” or “a determination or action by any person or body”) supported its conclusion.
While the court distinguished and took no issue with references to private agreements for limited facts (e.g., the identity of parties or whether there has been a breach of the agreement) or references to laws and regulations (e.g., the definition of “affiliate” in the U.S. Securities and Exchange Act of 1934), a Delaware corporation cannot simply create substantive charter terms through an external, private document.
– Public unavailability of private agreements. The DGCL requires charters to be publicly filed, but not a private agreement. The court reasoned that the public nature of charters makes basic information about the corporation available to both investors and third parties, but incorporating provisions by reference to non-public documents frustrates that statutory purpose. Furthermore, while federal securities laws might require public companies to file their governance agreements, that fact does not affect the interpretation of the DGCL applicable to all Delaware corporations.
– Circumvention of stockholder vote on charter amendments. The court observed that DGCL Section 242 requires both board and stockholder approval of charter amendments, whereas incorporation by reference of private party agreement provisions permits the contracting parties to amend their agreement on their own and thereby amend the charter automatically. According to the court, this would circumvent Section 242, thereby depriving stockholders of their voting rights.
Last week, I blogged about how PE sponsors have been accumulating quite a bit of dry powder since the beginning of 2024, but that it’s been the big players that have reaped the largest windfall. Now, it looks like these large sponsors are turning to the middle market, which has long been the domain of smaller PE funds. Here’s an excerpt from a recent MiddleMarket.com article:
A confluence of factors have made mid-sized deals particularly attractive for dealmakers of all sizes. Competition is heating up and it’s compelling all players to reassess their strategy. Here’s how it’s playing out.
“What we’re finding, and frankly what I’ve been surprised by having come from a much bigger fund, is we’re actually seeing quite a bit of competition at businesses that I wouldn’t have thought, from a size perspective, that billion-dollar-plus funds would be looking at,” says John Block, co-founder, CEO of Unity Partners, a Dallas-based mid-market PE firm.
Block defines companies with Ebitda from $20 million to $100 million as “classically middle market.” He’s watched this segment become more crowded in recent years. “We’re seeing quite a bit of competition where people are playing down market, even billion-dollar-plus funds in the five to 20 million Ebitda range, which has been surprising.”
Beau Thomas, managing partner at Agellus Capital sees a similar trend. “The processes for even smaller companies, as low as $10 million of Ebitda, remain very heated with larger funds coming down market. This is despite elevated interest rates, fundraising challenges, and the political backdrop,” he says. Agellus is a lower mid-market PE firm based in Clayton, Mo.
The article says that the decision of larger funds to target smaller companies has had a knock-on effect, resulting in traditional middle market players looking at smaller deals than they have in the past.
A recent Nixon Peabody memo provides an overview for emerging companies of the differences between the use of convertible debt and simple agreement for future equity for early stage financings. This excerpt addresses which of the two financing vehicles may be the preferred alternative for a particular company:
Both notes and SAFEs delay the valuation discussion since there isn’t a valuation upon issuance of the note or SAFE (although valuation may loosely be discussed if a valuation cap is to be agreed to). Delaying agreement on a valuation may provide emerging companies with more flexibility to keep the exercise price for options (based on the fair market value of the underlying stock) low, thereby making options more valuable as a tool to better attract talent. In addition, both convertible notes and SAFEs typically don’t include a change to the board of directors beyond a significant holder being a board observer, and the holders will not be considered shareholders with voting or other shareholder rights.
Still, SAFEs offer a few additional advantages to the company relative to convertible notes. They do not accrue interest or have a maturity date, and because SAFEs are not debt, their holders are not creditors. SAFEs also benefit from having a few well-understood industry forms, which could help streamline negotiations over notes. As a result, in all cases, SAFEs are the preferred mechanism for companies. Of course, at the end of the day, the investor may insist on a convertible note, and a company’s preference for a SAFE is only as good as the SAFE’s ability to attract investors.
That last sentence is a pretty good summary of the “golden rule” that every emerging company should keep in mind when negotiating with potential investors – “those who have the gold make the rules.”
In the current deal environment, private equity sponsors are increasingly looking for alternative ways of generating liquidity for their investments. A partial exit, in which the sponsor liquidates part of its investment in a portfolio company while retaining an ongoing interest in the business, is one increasingly popular alternative. This recent Foley blog addresses the potential benefits and challenges associated with partial exits. This excerpt provides an overview of some of the reasons why a sponsor might consider a partial exit:
There are several reasons why a firm might choose to do a partial exit instead of waiting for the exit event, including pressures from investors to generate liquidity. Firms have been holding onto their portfolio companies for extended periods since the end of the “zero interest rate” environment, which can lead to pressure from their investors. Bain & Company’s Private Equity Mid-Year Report states, “While exits also appear to have arrested their freefall, activity has landed at a very low level. And as limited partners (LPs) wait for distributions to pick up, most funds are still struggling to raise fresh capital.” A partial exit provides immediate liquidity that can be utilized to either invest in new opportunities or return capital to investors, helping manage the fund’s lifecycle.
There can also be a highly strategic component to a partial exit depending on who purchases an interest in the asset. A strategic investor can often bring in new expertise, resources, or access to new markets that can aid in the company’s growth. Suppose the investor brings complementary strengths to the partnership. In that case, it can also guide the company’s direction, positioning the company for the kind of growth that can lead to an exit at a much higher valuation down the road.
Finally, a partial exit provides a valuable mark to the portfolio’s valuation for the general partners and their marketing to new and existing LPs for the next fund.
Challenges associated with a partial exit include the need to ensure an alignment of interests between the sponsor and the incoming investor so that there is a clear strategic vision for the portfolio company, as well as the complexities associated with establishing an acceptable balance of control and decision-making authority between the sponsor and the new investor.
Last month, CFIUS issued its 2023 Annual Report to Congress. The report highlights key indicators of CFIUS’s activities and process, including the complexity and volume of its cases. The report says that there were 233 written notices of transactions filed with CFIUS in 2023 that it determined to be covered transactions, and that a subsequent investigation was conducted with respect to 128 of those 233 notices. The parties ultimately withdrew the notice and abandoned the transaction in 14 of these instances, either for commercial reasons or after being unable to identify mitigation measures acceptable to CFIUS and the parties involved.
There are a whole bunch of numbers in this report, and I could go on like this for quite a while, but that would be really tedious. Instead, I’m just going to point you in the direction of Davis Polk’s memo on the report and offer up an excerpt from that memo identifying some of the report’s key takeaways:
– Complex filings are not getting any easier (or shorter). As discussed above, the time to resolve investigations continues to increase, despite growth in CFIUS resources and staffing. In our experience, the increase in the number of questions from and information requested by the Committee during an investigation continues to drive longer timelines.
– Mitigation measures continue to expand. While the share of notices that resulted in the imposition of some form of mitigation measures remained the same as in 2022 (roughly 18%), it is significantly higher than in 2020 (12%) and 2021 (11%). Moreover, CFIUS’s indicative list of mitigation measures continues to expand, tracking changes to typical NSAs. Expansion has focused largely on data security and increased information and reporting requirements.
– Expect non-compliance with mitigation measures to be more heavily scrutinized and penalized. As discussed in our recent client update, CFIUS has increasingly focused on enforcement, and the Treasury Department issued a notice of proposed rulemaking earlier this year to amend its compliance and enforcement provisions to sharpen its enforcement authorities. Consistent with this trend, in 2023, CFIUS assessed or imposed four civil monetary penalties for noncompliance with material provisions of mitigation agreements, double the total number of previous penalties in the entire history of CFIUS, and issued its first formal finding of a violation of the mandatory filing requirements.7 The report notes that CFIUS member agencies increased investment in monitoring and enforcement resources in 2023.
– Shifting trends in non-notified transactions. CFIUS has made clear that investigating non-notified transactions is a priority of the Committee. As forecasted in the Committee’s 2022 report, though, the total number of non-notified inquiries has continued to decline, from 135 in 2021 and 84 in 2022 to 60 in 2023, as the Committee uses its increased investigative resources to work through a backlog of historical transactions.8 That said, the percentage of non-notified inquiries resulting in a formal request for a filing is trending upwards from ~6% in 2021 and ~13% in 2022 to ~22% in 2023, and we expect that CFIUS will continue to closely monitor for transactions of interest.
In Fortis Advisors v. Medtronic Minimed, (Del. Ch.; 7/24), the Delaware Chancery Court dismissed claims by a sellers’ representative that the buyer wrongfully deprived the target’s former stockholders of a $100 million contingent milestone payment. The Court rejected the plaintiff’s claims based on the earnout provision’s unusually buyer-friendly language concerning the buyer’s obligations with respect to the achievement of the milestone.
The merger agreement contained language stating that the parties intent was that “development, marketing, commercial exploitation and sale of the Milestone Products” could be exercised by the buyer in accordance with its business judgment and in its “sole and absolute discretion.” It went on to say that the parties acknowledged that the buyer’s ability to exercise its discretion “may have an impact on the payment of the Milestone Consideration.”
While the agreement also provided that the buyer could not “take any action intended for the primary purpose of frustrating the payment of Milestone Consideration,” it also said that the buyer would not “have any liability whatsoever to any [former target stockholder] for any claim, loss or damage of any nature that arises out of or relates in any way to any decisions or actions affecting whether or not or the extent to which the Milestone Consideration becomes payable.”
The plaintiff alleged that the buyer’s decision to defer hiring new salespeople, commencing a marketing program and refusing to pursue regulatory clearance and sales of a particular product were actions intended to frustrate payment of the Milestone Consideration. However, the Court concluded that “[d]eferring action and refusing action are functional opposites of “tak[ing]” action.” If the buyer had covenanted to use reasonable efforts to achieve the milestone, the Court said that those omissions might carry more weight, but not with the buyer-friendly language contained in the agreement.
The Court observed that the unusual language in the contract put the plaintiff in the position of having to satisfy a pleading burden that it just could not meet:
The Court first notes the unusually heavy burden that Fortis contractually imposed on itself. This is not a case where Medtronic covenanted to use “best efforts,” “commercially reasonable efforts,” or even “good faith efforts” to achieve the First Milestone. To the contrary, in an arm’s-length transaction, Medtronic secured for itself sole discretion to take actions that Medtronic knew would frustrate the First Milestone, so long as the action had some other primary purpose. Fortis freely assented to that arrangement. The Court is not aware of any Delaware precedent applying such a buyer-friendly contingent payment scheme, and the parties cite to none.
Thus, while Fortis is correct that Delaware law imposes a “‘minimal’ and ‘plaintiff-friendly’ standard” at the pleading stage, Fortis must contend with a voluntarily undertaken contractual standard that is far from plaintiff-friendly. To meet that standard, Fortis cannot simply raise an inference that Medtronic acted in a way that had the purpose or effect of defeating the First Milestone, Fortis must plead facts that raise an inference that Medtronic acted with the primary purpose of defeating the First Milestone. Fortis fails to raise the latter inference.
While the Court dismissed the plaintiff’s claims relating to the earnout, it allowed the plaintiff to move forward with claims that the buyer wrongfully withheld amounts held in an escrow account based on the buyer’s alleged untimely assertion of indemnity claims.
This recent Greenberg Traurig memo addresses the implications of the 2024 DGCL amendments that drafters of merger agreements, resolutions, and other corporate documents should keep in mind. This excerpt addresses implications of the provisions of new Section 147 of the DGCL permitting the board to approve a merger agreement in final or “substantially final” form on drafting board resolutions:
New Section 147 provides that, whenever the board of directors is required by the DGCL to approve an agreement, instrument, or document, the agreement, instrument, or document may be “in final form or in substantially final form.” Although “substantially final” is undefined in the DGCL, commentary suggests that it will be limited to inconsequential and immaterial changes. Board resolutions providing such approvals may now be drafted accordingly to permit some flexibility, though counsel should exercise caution when determining whether a board has approved a “substantially final” form of the applicable document. A more conservative approach would track preexisting best practices of board approval in final form.
The memo also addresses the implications of language in Section 147 permitting the board to ratify the final version of a merger agreement as of the date that it previously approved the agreement. It recommends that if the board previously authorized a version of the agreement that wasn’t completely finalized, it may be prudent for the board to adopt pre-closing resolutions ratifying the agreement retroactive to the date of the board’s earlier action approving the agreement.
Over the past few years, nothing’s been hotter than AI. In fact, I haven’t seen anything generate as much buzz among lawyers since the height of the dotcom craze, when some members of my old law firm’s management began to dress like Steve Jobs & wander the halls talking about how we needed to “get the Internet space.” Since we were based in Cleveland, about 95% of our clients at the time were traditional rust belt businesses & the 1% or so that were dotcoms didn’t have any money, but that still didn’t stop us from having fun while the craze lasted.
Anyway, this brief Vinson & Elkins memo provides some helpful insights into the risks associated with buying or investing in tech businesses focusing on AI and some guidance on how to manage them. This excerpt addresses the IP-related risks that buyers and investors need to scope out:
Transactions involving AI pose intellectual property (“IP”) and ownership risk in three significant areas: the AI models, the data used to train them, and the output. Prior to acquiring a business that uses an AI model, decision-makers should conduct diligence to assess how the model was created, by whom and the resources used. AI models can be developed using internal company resources, but many also use open source software code or commercial third-party software in the development of the model. The model may be created or modified by employees, contractors or other third parties.
The AI model is then trained, sometimes with large and varied datasets. AI providers may obtain the training data from internal resources, but many also obtain training data from customers, vendors, employees, websites (through crawling and scraping), books, photographs, maps, or otherwise from third parties. A model may then be fine-tuned for a specific application. Any use of training data, code or other information from others creates a risk that the others may have an IP ownership stake in the model.
Buyers should also carefully review customer agreements and licenses where third-party rights are obtained for use in training AI models. If an AI model is used to generate output, that output will also be subject to IP rights. The owners of the model and training data may have a claim to IP rights in the output, as may anyone prompting or running the AI model. Generative AI models may also generate content that infringes IP rights of third parties who had nothing to do with the AI model, its training or running the model.
The memo says that it’s essential not to assume that the AI model, training data or output is owned by the target or that it’s free to use. The law in this area is unsettled, and the memo urges buyers who want to minimize risk to confirm that the target either owns or has valid licenses covering any uses of the model, training data and output.
I don’t usually delay blogging about Chancery Court decisions, but I did last week after working my way through Vice Chancellor Laster’s opinion in Seavitt v. N-Able, (Del. Ch.; 7/24). The case is the latest in the series of post-Moelis cases challenging governance provisions in stockholders’ agreements working their way through the Chancery Court.
Since the case was decided under pre-market practice amendments law, you probably won’t be surprised to learn that the challenged provisions didn’t fare well. That being said, parts of the decision are pretty interesting – such as the discussion of the extent to which a charter provision may be dependent on “facts ascertainable outside of the document” and what constitutes “facts” in this context. I think I may blog about that aspect of the decision later this week.
So, my delay in blogging wasn’t because I didn’t find the opinion interesting. Instead, my problem is the same one that it appears VC Laster had with the case – aside from the impact on the parties involved, most of it seemed like a waste of time. That’s because when the Delaware General Assembly adopted this year’s amendments, it provided that Section 122(18)’s Moelis fix wouldn’t apply to pending cases. As the Vice Chancellor put it, that created a “donut hole”:
It seems likely that the proponents of the Market Practice Amendments did not want to appear to be affecting pending lawsuits and therefore created the donut hole. Speaking for myself, I would have preferred the Market Practice Amendments without the donut hole. Once a decision has been made to change the law retroactively, there is no reason to force the courts to apply the superseded law to a smattering of cases. That is a waste of judicial resources. It also risks creating confusion because there will be more extant decisions addressing issues where the Market Practice Amendments could lead to a different result.
But maybe I jumped the gun on concluding that there’s not much to be gleaned from the opinion for post-market practice amendment cases. On Friday, I found a thread over on X in which Ann Lipton pointed out that in addressing the enforceability of the various governance provisions challenged in this case, Vice Chancellor Laster may have provided some hints on how he’d come out on these issues under the new regime established by Section 122(18).
The Chancery Court recently dismissed breach of fiduciary duty claims arising out of a $400 million reduction in the purchase price to be paid to target stockholders as a result of post-signing equity awards to insiders that allegedly violated the terms of the merger agreement. In In re Anaplan, Inc. Stockholders Litigation, (Del. Ch.; 6/24), Vice Chancellor Cook held that because the transaction was approved by a fully informed and uncoerced vote of the target’s stockholders, it was subject to business judgement review under Corwin.
The key takeaway from this decision may just be that if you want to make a quick exit from a lawsuit based on Corwin cleansing, your best bet is to lay the whole situation out in your proxy disclosure without sugar coating it. This excerpt from Vice Chancellor Cook’s opinion suggests that’s exactly what the target did here:
Immediately up front in the Supplemental Proxy, the Board set forth its position, which was readily understandable to any stockholder reading it—that the Board believed the Company and its directors and officers had acted in good faith and in compliance with the Original Merger Agreement, but that a bona fide dispute had arisen with Thoma Bravo on that issue.
Stockholders would further understand that, rather than continue to dispute the issue and risk losing the deal, the Board made the business judgment that it was in the best interests of Anaplan and its stockholders to agree to a price reduction in return for securing the still premium transaction and enhanced closing certainty. This explanation was followed by an additional eight pages laying out in substantial detail the Board’s position, Thoma Bravo’s position, the dispute between the counterparties, and the negotiations over an amended merger agreement over a roughly two-week period.
In order to satisfy Corwin, it’s not enough that the stockholder vote is fully informed – it must also be uncoerced. The plaintiffs argued that the circumstances of the transaction involved “situational coercion,” because the status quo was so unpalatable that stockholders had no alternative but to vote for the deal at the reduced price. Specifically, they argued that if the stockholders didn’t approve the deal, the stock price would plummet. Vice Chancellor Cook rejected that argument as well:
To be sure, a stockholder would prefer more money for her shares to less, all things being equal. This would seem to hold true in all transactions involving rational economic actors. But it does not follow that a merger, or the vote thereon, is situationally coercive under our law simply because the merger offers a premium relative to the expected trading price for shares if stockholders do not approve the deal.
Anaplan stockholders had a choice to accept the revised merger or to vote it down and thereby retain their shares in the standalone company. Plaintiff does not allege the Company, or its shares, would be worthless or even materially impaired in terms of their intrinsic value. Anaplan stockholders had the opportunity to retain an interest in a multibillion-dollar company with significant revenue. The difference between good, better, and best here is not grounds for situational coercion.
The Vice Chancellor also rejected arguments that the transaction was “structurally coercive,” holding that those arguments boiled down to “a beef with Corwin itself.” He concluded that the plaintiffs were essentially arguing that the stockholders’ overwhelming vote to approve the deal shouldn’t be accorded any weight because it was bound up in their desire to receive a premium. VC Cook concluded that this ain’t the way it works:
Plaintiff’s argument seems to suggest that corporations, and our courts, have been missing structural coercion inherent in merger votes for nearly a decade. Corwin, however, establishes a framework in which our law respects equity owners’ fully informed decision to cash out their shares for a premium via a merger and accords that decision cleansing effect rather than labeling it coercion. That is a very deliberate feature, not a bug, of the system.