In a post-trial opinion in In re Trados Incorporated Shareholder Litigation, the Delaware Court of Chancery applied the entire-fairness standard of review to a merger transaction that triggered payments on the preferred stock of venture capital (VC) investors while paying common stockholders nothing. The court held that the directors appointed by the VC investors were personally interested in the transaction and that the board had wrongfully considered only the interests of the preferred stock, to the exclusion of the interests of the common stockholders. However, though the court considered the board's process procedurally unfair, it deemed the deal fair based on price, because the value of the common stock in Trados as a going concern would have been worthless.

The case arose from a 2005 merger between Trados Incorporated (Trados) and SDL, plc (SDL) and was the subject of an opinion in 2009 in which the court denied the defendants' motion to dismiss (see Legal Update, DE Court of Chancery Denies Motion to Dismiss Claim of Breach of Duty of Loyalty by Directors Who Favored Preferred Stockholders). Before entering into the merger with SDL, Trados was a VC-backed company, founded in 1984 to develop proprietary desktop software for document translation. Starting in 2000, the company raised several rounds of VC financing, in each case issuing a new series of preferred stock with similar, typical features:

For an example of a certificate of designation for preferred stock containing these and other features, see Standard Document, Certificate of Designation of Preferred Stock (Convertible, Double-dip Participating).

At the time of the merger with SDL, the board consisted of seven directors, including two management directors, three VC-appointed directors and two outside directors. In the years leading up to the merger, the company showed an ability to generate revenue, but could not achieve meaningful profitability. The VC directors updated the partners at their respective VC firms throughout this period, advising them that while an exit was achievable, they were not likely to see significant returns on their investments.

In July 2004, the board hired a new CEO, Joseph Campbell, who understood his role to be to generate enough short-term profitability to make an exit more likely, at higher valuation than had been previously available, and to bring the company closer to that exit. The board also adopted a management incentive plan that would provide senior management with an escalating percentage of sale proceeds depending on the valuation achieved. The evidentiary record continued to reflect the investors' singular focus on an exit for their investment, with no discussion of the value of the common stock or of the possibility of continuing to operate the company for the benefit of the common stockholders.

Campbell had significant success in his time as CEO of Trados, quickly achieving profitability for the business and reaching agreement with SDL on a merger that would pay $60 million, split $50 million/$10 million between cash and stock. Owing to the terms of the incentive plan, the first $7.8 million of proceeds went to Campbell, the other management director (and company co-founder) Jochen Hummel (who also held out for additional compensation for agreeing to a non-compete with SDL), and other employees. The remaining $52.2 million went toward satisfying the total combined liquidation preference of the preferred stock of $57.9 million (because of an escrow of $4 million under the merger agreement for indemnification claims, only $49.2 million of the proceeds were actually paid to the preferred stockholders). Without the incentive plan, the common stockholders would have been entitled to $2.1 million in proceeds, but instead received nothing. The merger agreement was approved by the required percentages of the preferred stock and the common stock, with the VC investors owning enough of the preferred stock to approve the merger on their own.

The plaintiff, a common stockholder, initially brought an action for appraisal of his shares, but eventually brought a second action alleging a breach of the fiduciary duty of loyalty as a result of discovery during the appraisal action. The plaintiff alleged that the board ignored the interests of the common stock by focusing entirely on achieving an exit that would benefit the preferred stockholders, even though the company could have continued to operate profitably as a stand-alone entity.

In a lengthy post-trial opinion, the court found that a majority of the directors had conflicts of interest, which necessitated review under the standard of entire fairness. The entire-fairness standard demands review for objective fairness of both the procedures taken and the price obtained, though these factors are ultimately combined in a unitary determination of fairness. In its review, the court found that the board had failed to deal fairly with the common stockholders by failing to recognize its inherent conflicts or implement any procedural protections for the common stock. However, the court determined that the transaction ultimately passed review for entire fairness based on price, because the common stock had zero value in any scenario.

The Trados decision explodes standard operating assumptions inherent in the venture capital model. The facts of the case do not reveal any behavior on the part of the board of Trados that might be characterized as extraordinary or particularly underhanded, yet the court identified several areas of conflicts of interest and unfair dealing. Although there is some comfort to be found in the ultimate ruling that a price can be fair even when the common stockholders receive no payment, the decision reveals significant fault lines that VC investors and their counsel must repair in future transactions to avoid review under entire fairness and the potential for a finding of breach of fiduciary duties. Some possibilities for consideration include: