• Private Equity Investments through the Purchase of Redeemable Preferred Stock—Is it Time to Consider Structural Alternatives?
  • May 23, 2011 | Author: Andrew Hulsh
  • Law Firm: Mayer Brown LLP - New York Office
  • Many private equity investments have been structured through the purchase of an issuer’s redeemable preferred stock. This structure provides investors with a preference over common shareholders in one or more areas, including liquidations, voting, board representation and approval over specified matters, while also creating a liquidity mechanism for the shares. As a result of a recent opinion by the Delaware Court of Chancery, it may be time to consider structural alternatives to the purchase of redeemable preferred stock.

    Under Section 154 of the Delaware General Corporation Law (the “DGCL”), shares of preferred stock with traditional redemption provisions may only be redeemed out of a corporation’s surplus, defined as the “excess of net assets over the par value of the corporation’s issued stock.” The language in a Delaware corporation’s charter (or certificate of designations) that typically has been used to create redeemable preferred shares provides that shares of preferred stock may only be redeemed from “legally available funds.” This provision, when read in conjunction with Section 154, has led many lawyers and investors to interpret “surplus” and “legally available funds” as one and the same requirement.

    The Delaware Court of Chancery recently addressed this interpretation in SV Investment Partners, LLC v. Thoughtworks, Inc.,1 in which the court concluded that treating surplus as identical to legally available funds may be incorrect.

    SV Investment Partners involved the purchase by SV Investment Partners, LLC (SVIP) of more than 94 percent of the Series A preferred stock of Thoughtworks, Inc. (Thoughtworks). Pursuant to Thoughtworks’ charter, SV was granted the right to have the Series A shares redeemed for cash from “funds legally available therefor,” beginning five years after their issuance. SVIP and other preferred shareholders sought to exercise their redemption rights five years following the issuance of the Series A shares and demanded that Thoughtworks redeem all of their Series A shares. In reviewing their demand, the Thoughtworks board of directors determined that, despite the possible existence of a surplus, the company could not redeem all of the Series A shares, concluding that such a redemption would endanger Thoughworks’ liquidity and jeopardize its long-term health.2

    In its decision, the court stated that “funds legally available” was a much a broader term than “surplus.”  In the court’s view, “funds legally available” contemplates whether a company has or can readily access cash, and whether such cash could be distributed without running afoul of the DGCL and/or common law restrictions regarding insolvency, creditors’ rights and the impairment of capital. Furthermore, the court pointed to DGCL Section 160, which refers only to “capital,” not surplus, and other statutes clarifying that a company can have a surplus, but still not possess available funds from which it can legally redeem shares.

    Additionally, based on its review of common law, the court concluded that a corporation “cannot purchase its own shares of stock when the purchase diminishes the ability of the company to pay its debts, or lessens the security of its creditors,” even if the corporation has a “surplus.” The court explicitly stated that even if the charter or certificate of designations expressly provided that the redemption would be made to the extent of the corporation’s surplus, or failed to include any language regarding the sources of funds or other requirements relating to a company’s financial condition as a prerequisite to redeeming its preferred shares, Delaware courts would nonetheless require the company to have available funds from which it can legally redeem shares.

    The court also gave considerable deference to the business judgment of Thoughtworks’ board of directors, when the board determined that a redemption of the Series A shares would jeopardize the financial health of the company. Of note, the court stated that, under Delaware law, a plaintiff seeking to challenge a deliberate judgment by a board of directors with respect to whether funds are legally available must prove that a board (i) acted in bad faith, (ii) relied on unreliable methods and data or (iii) made a determination “so far off the mark as to constitute actual or constructive fraud.”

    In light of this recent decision and given the considerable deference that the court has provided to corporate boards in connection with redeeming preferred stock, financial sponsors, venture funds and other investors should consider other options when contemplating an in investment in redeemable preferred stock.

    In particular, the court suggested that the purchase of either debt with warrant coverage or convertible debt would allow an investor to reap the upside benefits of equity while providing for a right of repayment to the investor, regardless of a company’s financial condition or prospects (subject to bankruptcy laws and the laws of priority).

    The court also suggested that investors seek “penalty provisions” when negotiating the preferred investment, such that when a valid redemption demand goes unsatisfied, rights such as the ability to nominate members to the board, controlling a sale process and/or issuing additional shares, are granted to the holders of redeemable preferred stock.

    The decision in Thoughtworks should cause investors seeking to obtain liquidity through the purchase of redeemable preferred stock to carefully consider whether the company in which they are investing is likely to have legally available funds, and not merely surplus at the time that the redemption request is expected to be made. If investors are substantially concerned that the company in which they are investing will not have legally available funds to redeem the preferred shares at the time that they expect to make a redemption request, we agree with the court in Thoughtworks that investors consider purchasing debt with warrants, or convertible debt, in lieu of redeemable preferred stock (subject to any covenants contained in any credit agreements or indentures relating to any existing or anticipated debt financings), and insist on certain rights and penalties if the preferred shares are not redeemed in full.

    1 SV Investment Partners, LLC v. Thoughtworks, Inc., C.A. No. 2724, WL 2010 4547204, (Del. Ch. Nov. 10, 2010).
    2 SVIP, in arguing that Thoughtworks possessed the legally available funds to satisfy its redemption obligation, presented expert evidence indicating that Thoughtworks’ surplus should be valued between $68 million and $157 million.