Alas, poor Erlich! We knew him; ‘a fellow of infinite jest, of most excellent fancy; he hath borne us on his back a thousand times; and now,’ as Jared poetically recounts, “Erlich’s Bachmanity boondoggle has led to his being unceremoniously bucked off the Pied Piper unicorn, [lock-] stock-and-Board-seat-wise.” Unfortunately, Erlich’s lavish over-spending of Bachmanity’s capital, combined with his personal liability for Bachmanity’s debts, have brought Erlich to the brink of bankruptcy. He’s so desperate for funding he’s willing to sell his Pied Piper shares to dig himself out of his hole. But yet again, the “onerous terms” that Richard accepted when he took Russ Hanneman’s investment rear their ugly head. Previously these terms enabled Raviga to take control of Pied Piper’s board and fire Richard. Now Laurie uses the terms to block Erlich from selling half his shares to Russ for $5 million, and forces Erlich to sell all his shares to Raviga Capital for the exact amount of Erlich’s debts ($713,000). This leaves Erlich with nothing except extreme public ridicule.
From Erlich’s perspective, Laurie’s powers must appear outrageous and ridiculous—but are they? Well, not exactly. It turns out that many privately-held companies have restrictions on the transfers of their shares, and there are a wide variety of possible restrictions. One common restriction is a right of first refusal (“ROFR”). Typically, a ROFR gives the company first, and the preferred shareholders second, the right to purchase common shares from founders, employees or other investors at the same price offered by the potential buyer. For example, when Erlich got Russ’s offer for half of his shares, a ROFR would have given Laurie the right to step in and purchase those shares from Erlich instead of Russ, provided she paid the same price Russ offered—$5 million. Interestingly, many ROFR agreements also provide for a “co-sale” right, usually to preferred investors. This means that the shareholders who have co-sale rights could have claimed the right to sell a pro rata portion of their shares to Russ/Raviga at the same price offered to Ehrlich for his shares. For example, if a co-sale provision gave them co-sale rights, Richard, Monica, Dinesh, Gilfoyle and Raviga might have each had a right to sell some of their shares as part of any sale by Erlich. This would have reduced the number of shares Erlich could sell, but maybe the others would have loaned him the proceeds of their sales to get him through his rough patch?
At any rate, clearly Laurie didn’t match Russ’s offer, so we most likely aren’t dealing with a ROFR. Instead, as Laurie explained, when Russ invested he obtained a restriction that allowed a majority of Pied Piper’s board to vote to block any transfer of the common, “restricted” stock. Since Raviga Capital controls Pied Piper’s board, Laurie simply “voted” against the sale to Russ. She also made it clear she would block any other sale except to Raviga, at the price Laurie dictated. Erlich was left with no choice but to sell to Laurie at her rock-bottom price. As unfair as it may seem to Erlich, a restriction that prohibits any transfers of stock except with approval of the company, or approval of the preferred shareholders, is usually permissible. For example, Delaware law explicitly permits this type of restriction, as well as ROFR provisions, and provisions requiring holders of restricted stock to transfer their shares back to the company under certain conditions (like if they leave the company).
So the restrictions on Erlich’s stock are not totally whacky, and are likely quite legal. But why are they there? Did Russ insist on the restrictions just so he could further torment Pied Piper and the team? Maybe not; and in fact, Delaware courts generally will not enforce restrictions on stock transfers unless the restrictions were imposed for a ‘reasonable corporate purpose.’ It turns out that privately-held companies (and more specifically, their VC investors) can have a variety of ‘reasonable’ purposes. For one thing, companies often wish to limit the number of investors so that they stay under the threshold that would force the company to register as a public company with the SEC. Although this threshold has been raised in recent years, it still may be a concern for mature private companies approaching, but not yet ready for IPO. Limiting share transfers can ensure that outsiders, and even competitors, don’t become disruptive shareholders with rights of access to sensitive company information. Prohibiting founders and early employees from “cashing out early” could help keep them focused on the long-term success of the company. Any of these are likely to satisfy the Delaware courts and permit a company to restrict the transfer of its shares.
This doesn’t mean a company, or VCs, can impose restrictions willy-nilly. For example, Delaware law states that restrictions will not be binding on shares issued prior to the imposition of the restriction, unless the holders of those shares vote for or agree to the restrictions. Other states’ courts impose similar rules. Erlich received his shares in exchange for hosting Pied Piper in his incubator even before Pied Piper had any investors. Russ required the transfer restrictions as a condition of his later investment, and to make the restrictions iron-clad and unchallengeable by Erlich, Russ would have obtained Erlich’s consent. Russ could have required the restrictions as part of his “protective provisions,” which are provisions that give the holders of the preferred stock, or a series of preferred stock, the ability to block/veto certain company actions. In other words, the restriction could have required that the majority of the preferred shareholders would need to consent to any transfer of the restricted stock, or conversely, would have the right to block any sale (even if the board had approved the sale). Instead, Russ apparently demanded the right of a majority of the board to vote to block any transfers. Either way, Erlich almost certainly agreed to the restrictions by voting in favor of them and/or signing on to an amendment of Pied Piper’s certificate of incorporation when Russ made his investment. From then on, the fate of his shares was sealed.
Even though there’s nothing inherently wrong with Pied Piper’s board having the right to block Erlich’s sale to Russ, Laurie may have violated her fiduciary duties in taking advantage of that right. While shareholders generally have a right to vote their shares in their (self) interest, directors must act in the best interests of the company. Specifically, directors must act to maximize the long term value for the common shareholders. Here, Laurie’s actions may have depressed the value of the common shares, at least in the short term (e.g., she set an actual price that was far below what Russ offered). Even worse, Laurie appears to have engaged in “self-dealing”—using the votes of Raviga’s directors to give Raviga a benefit (the ability to acquire additional shares dirt cheap) that was not provided to the other shareholders. This would be even more egregious if there had been other preferred investors who were denied the opportunity to participate in the deal. Self-dealing transactions may be void or voidable under Delaware law where an action is approved by interested directors and their financial interest was not disclosed to the rest of the Board or approved by impartial directors. Here Richard was the lone uninterested director and he was completely unaware of Erlich’s sale until after it happened, so he wasn’t informed and certainly didn’t vote to approve it!
Erlich’s situation should be a wake-up call to the other Pied Piper guys about Raviga’s power over them, and a good lesson on how “onerous” terms can continue to haunt a company for years despite its overall performance and reputation. Even though Russ no longer holds any Pied Piper shares, the terms he negotiated will likely be difficult to get rid of. Investors who negotiate the terms usually make sure the terms can’t be eliminated without those investors’ consent. And future investors are likely to demand the same rights. Thus, even though Pied Piper is now the hottest company in Silicon Valley, Richard, Erlich and the rest of the team are stuck under the thumb of Raviga and Laurie because their stock is subject to the same onerous terms they accepted during their darkest days.
Erlich definitely got a raw deal, but as we’ve seen over the past few episodes, he set himself up for this fall. Let’s hope he brings some hard-won wisdom to his new role as “CEO.”
With special thanks to corporate attorney Kevin Rogan for his insights.