THE BLOG
10/18/2013 10:59 am ET Updated Jan 23, 2014

Litigation Between a Founder and Outside Investors

Once a privately held company obtains outside investors, there may be tensions between the desire of the founder of the business to maintain control and continue the successful initial vision, and the strategic plans of the investors. An October 11, 2013, memorandum opinion by the Delaware Court of Chancery in Klaassen v. Allegro Development Corporation provides a lengthy, detailed and public chronicle of events leading to litigation between the founder and outside investors. In brief summary, the outside investors received preferred stock while the founder continued to hold most of the common stock and was CEO and a member of the Board of Directors. Eventually the Board removed the founder as CEO. One factual thread was the failure of the parties to fully implement agreements and clearly determine whom outside legal counsel represented. These failures only further complicated the rights and duties of the parties. This comment will not recite the factual details but will focus on some features of Delaware law as discussed by the judge.

Must the Board provide advance notice of adverse action (such as a CEO firing) to a person who has the power to change the composition of the Board? If a lack of notice violates a provision in the corporate bylaws, the Board's action is void. If the lack of notice seems unfair (inequitable), the Board's action is potentially voidable (may be cancelled) by a court. However, a voidable analysis opens the door to the defendant's equitable defenses of latches and acquiescence.

Laches means that an individual unreasonably delayed in asserting rights so that the defendant has significantly (materially) changed his or her position. The time for latches may be shorter than a statute of limitations. This is based upon fairness, not legislation.

Acquiescence means that an individual knows the facts but is inactive in responding for some time so that the inaction appears to imply approval. Some statements of displeasure alone are not sufficient to defeat an assertion of acquiescence. Again, this is based upon fairness, not legislation.

An individual may have the exercise of rights granted by the corporate charter and bylaws restricted by a contractual shareholders' agreement that the individual entered into. That happened, according to the judge, in this case so that the founder could not take action to elect or remove directors and fill vacancies on the Board. However, after terminated as CEO, the founder remained a director because no one attempted to remove him. Had removal action been undertaken, the founder could have voted his common stock to elect himself to the Board. In a complex analysis that considered the corporate charter, the bylaws, the shareholders' agreement, and Delaware corporation law, the judge determined that some directors were properly installed or removed and others were not. The end result, in the opinion of the judge, was that the founder is no longer the CEO and there are two vacancies on the Board. This opinion may be appealed to a higher court.

Several lessons may be apparent. Many individuals will conclude that private dispute resolution, such as arbitration, is preferable to a messy public airing of grievances that only serves to tarnish individuals and may cause both insiders and outsiders to question the stability of the corporation. Founders who solicit outside investors must anticipate conflicts concerning an appropriate corporate vision and future strategies. Investors must anticipate how difficult it may be for a founder to relinquish control and see the founding vision changed, especially in light of the hard work that is necessary to grow a business to the stage that outside investors take notice. Whatever agreements the founder and outside investors make must be fully implemented. Excessively complex agreements lead to misunderstandings concerning their meaning and how they interact with other agreements between the parties. The legal force of a shareholders' agreement should not be underestimated. Attorney-client status must be clear and transparent. All parties must take immediate and decisive legal action if their rights are violated. Finally, knowledgeable individuals will have differing opinions. This must be anticipated and addressed appropriately prior to disputes.