A company that needs to raise capital asks to promote the matter through its board of directors. In many cases, the members of the board of directors are representatives of a previous investor in the company, who views himself as a potential investor in the current round of financing.
The directors on behalf of the original investor find themselves in quite the conundrum: on the one hand, they are supposed to act in the best interests of the company, but on the other, the investor by virtue of whom they were appointed, often asks them to promote interests that may clash with the company’s best interests.
What considerations are such directors permitted, not to say obligated, to take? How can they try to solve these inherent conflicts of interest ahead of time?
In the Best Interests of the Company or of the Investor?
A director’s position is very influential and entails outlining company strategy and impacting significant decisions.
This is true tenfold in the case of a director appointed to the company’s board of directors by an investor who has invested capital in the company, and is therefore in the unique position of having to act in the best interests of both the investor and the company.
It is worth mentioning that in most cases these interests are similar, not to say identical: actions and decisions made by the director in his capacity within the company, that then go on to contribute to the company’s success, and as a result increases its share price, will undoubtedly also yield returns for the investor. As an aside, we shall note that even if the director was appointed by an original investor who invested in the company through debt securities, the interests are still similar in most cases, since the company’s success and establishing its position are of utmost importance even for an original investor expecting payment from the company.
Nevertheless, there are instances where the interests of the original investor do not align with those of the company. The most obvious example is future venture rounds, a complex and arduous process through which the company and its executives seek to raise the maximum amount of capital possible using a high valuation of the company. On the other hand, the original investor sees himself as a potential investor during this venture round as well. This creates a problem since the original investor’s motivation is in contrary to the objectives of the company and its executives: to obtain the greatest number of shares (which then comes with significant legal rights) for any given investment.
This means that the original investor strives to receive the lowest possible share price, in order to increase his stake in the company.
The difficulties facing the director who was appointed to the board by such an investor are clear: on the one hand, as a director in the company he has a duty toward it, and he must exercise judgment for the good of the company (only), whereby he must direct the company’s executives to raise the maximum amount of capital at the highest possible share price. On the other hand, as a director on behalf of the original investor, he can find himself making it difficult for alternative investment proposals, since he is trying to promote investment offers made by the original investor (as his assignee).
From a legal standpoint, the Companies Law and prevailing case law set clear standards regarding the duties a director on behalf of an investor has toward the company. According to Section 254 of the Companies Law, 5759 – 1999 (“Companies Law”) a company official has a fiduciary duty to the company, he must act in good faith and in an acceptable manner, as well as, inter alia, refrain from taking actions that present a conflict of interest between his position in the company and another position he occupies, while also refraining from taking advantage of a business opportunity of the company to benefit himself or others.
From the general to the specific, the director’s fiduciary duty is first and foremost to the company, and he must avoid situations where he abuses his position and status while trying to promote benefits for the original investor over the best interests of the company when the company is attempting to raise capital.
In this context, it is important to note that in young companies, in a majority of cases, most shares belong to an investor/s, and as a result most directors have been appointed by said investor/s. This means that when the day comes to evaluate further venture rounds, most directors sitting on the company’s board are representatives of the investor/s, and therefore their vote is tainted by an inherent conflict of interest as well as personal interest.
In such case, the law states that voting is deferred to the general meeting of shareholders, and indeed the shareholders, seeing as they have a controlling interest, also have a fiduciary duty to the company (see Section 193 of the Companies Law).
Incidentally, in companies where the director/s on behalf of the investor do not constitute a majority, they usually have veto rights (restrictive provisions) to object to a resolution regarding future investment in the company, i.e., without their support – the company cannot complete the funding.
In this context, we shall note that the fair and most trivial solution is that an incumbent director representing an investor who previously invested in the company cannot reject an attractive investment offer without presenting to the company an alternative investment offer with terms at least as good as those it has received from the third-party. Doing so would eliminate rejections of investments that are beneficial for the company, and enable the company to raise the capital it needs to further develop its business.
Moreover, in cases where the question of the potential investor’s identity is also a significant consideration for the company when weighing alternative investment offers (for instance, when the company wishes to raise capital from a strategic partner, etc.), the original investor must support such investment offers, while preferring to try to promote his own narrow interests as an investor.
Directors have a duty to act in the best interests of the company and its business. In certain cases, directors must detach themselves from the narrow interests of those who assigned them so that they do not act in contrary to their duties to the company, and end up undermining the very values that were supposed to guide them when making decisions.
In every transaction involving those who appointed such directors and the company, the directors would be best served to avoid a conflict of interest and opt to refrain from making a decision, or, alternatively, attempt to defer any decisions to the general meeting of shareholders, since they too have a fiduciary duty to the company.