For the past few months, I’ve been discussing the rights of VC investors in connection with preferred stock financings, such as veto rights, redemption rights, liquidation preferences, Board seats, etc. All of these rights are contractual in nature – that is, they are initially provided for in a term sheet and then incorporated into the definitive documentation.
There is another set of rights that many entrepreneurs may not be familiar with, however: State law rights. These are rights granted to stockholders pursuant to the respective laws of the company’s State of incorporation and are often the only rights that minority common stockholders have. Whether a minority common stockholder is a founder, advisor or even a friends/family investor, he or she will usually not be contractually granted any of the rights that are typically granted to preferred stockholders.
Accordingly, I thought it would be helpful to examine these non-contractual rights. Because these rights are governed by State law, I will focus on the State of Delaware — where most companies are incorporated. Below are three significant rights of minority stockholders.
Inspection rights – A minority stockholder has the right to inspect the corporation’s stock ledger, a list of its stockholders and its other books and records (and to make copies of such items). There are, however, certain formal procedural requirements that the stockholder must comply with, including making a written demand upon the corporation, “under oath” and stating a “proper purpose.”
There are also some tricky evidentiary issues. For example, if a stockholder merely seeks to inspect the corporation’s stock ledger and/or list of stockholders, the burden of proof is on the corporation to establish that the demanded inspection is for an improper purpose. However, if a stockholder seeks to inspect the corporation’s books and records, the burden of proof is on the stockholder to establish that the demanded inspection is for a proper purpose.
The Delaware statute defines “proper purpose” to mean “a purpose reasonably related to such person’s interest as a stockholder.” Delaware courts have construed this language broadly to provide stockholders with a reasonable means to protect themselves (and their investment) – though the “proper purpose” must be sufficiently specific.
Right to bring a derivative claim – A minority stockholder has the right to bring a derivative claim on behalf of the corporation, provided that certain “standing” requirements are met, including that he or she was a stockholder at the time the cause of action arose. In a derivative claim, the recovery runs to the corporation, not to the stockholder individually.
Derivative lawsuits are generally brought when directors and/or officers of the corporation have breached their fiduciary duty owed to the corporation. There are two broad categories of breach of fiduciary duty: a breach of duty of loyalty or a breach of duty of care. For example, a minority stockholder could bring a derivative suit against a director or officer who allegedly used the corporation’s assets for personal gain (a breach of duty of loyalty).
The stockholder must typically first make a written demand on the corporation’s board of directors to be permitted to proceed with a derivative suit. The board can either accept or reject the demand. Delaware law, however, recognizes a “futility” exception and excuses demand if the stockholder alleges particularized facts creating a reasonable doubt that the directors are disinterested and independent or that the challenged transaction “was otherwise the product of a valid business judgment.”
Protection against oppression by the controlling stockholders – Finally, minority stockholders have certain protections against oppression by the controlling stockholders. In fact, the controlling stockholders owe fiduciary duties to the minority stockholders. As the leading Delaware case provides: “[W]hen a shareholder presumes to exercise control over a corporation, to direct its actions, that shareholder assumes a fiduciary duty of the same kind as that owed by a director.”
Because of this, a minority stockholder may bring a direct claim (as opposed to a derivative claim) against the controlling stockholders for breach of fiduciary duty where the controlling stockholders have forced the minority stockholders to sell their shares at a price below their fair market value or caused the corporation to issue additional shares of capital stock to the controlling stockholders at an inadequate price. They may also have cause if the controlling stockholders reduced the economic value of the minority stockholders’ shares disproportionately.
Startup owners: Got a legal question about your business? Submit it in the comments below or email Scott directly. It could end up in an upcoming “Ask the Attorney” column.
Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a law firm specializing in the representation of entrepreneurs. Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.