SV Investment Partners, LLC v. Thoughtworks, Inc.

Court of Chancery of Delaware
7 A.3d 973, 2010 Del. Ch. LEXIS 223, 2010 WL 4547204 (2010)

ELI5:

Rule of Law:

A corporation's contractual obligation to redeem preferred stock "for cash out of any funds legally available therefor" under Delaware law is not limited solely to the existence of "surplus" but also requires the actual availability of cash or liquid assets, and that the redemption would not render the corporation insolvent (either balance-sheet or cash-flow) or jeopardize its ability to continue as a going concern.

Facts:

Roy Singham founded ThoughtWorks in 1993 as an information technology professional services firm, emphasizing a culture of elite software developers.
ThoughtWorks' business model involved short-term client engagements, leading to volatile cash flows and management's effort to maintain a cash cushion for unexpected shortfalls and seasonal lows.
In 1999, ThoughtWorks began considering an initial public offering (IPO) and sought private equity investment, believing an existing venture capital investor would enhance its credibility.
SVIP received an offering memorandum for ThoughtWorks, recognizing its strong track record but also that it was paying a high valuation, with both parties anticipating an IPO within one to two years.
During negotiations, SVIP and ThoughtWorks discussed redemption rights, compromising on a five-year redemption right, subject to the legal availability of funds and a one-year working capital carve-out.
On April 5, 2000, SVIP invested $26.6 million in ThoughtWorks in exchange for 2,970,917 shares of Series A Preferred Stock.
The NASDAQ market peaked in March 2000, and by 2001, it had fallen significantly, making an IPO an unrealistic possibility for ThoughtWorks in the near term.
SVIP first exercised its redemption right for the Preferred Stock in 2005, but ThoughtWorks did not have and could not obtain the cash to redeem the Preferred Stock in full.

Procedural Posture:

In May 2005, SVIP sent demand letters exercising its redemption rights for the Preferred Stock, effective July 5, 2005.
ThoughtWorks' Board held a special meeting on July 1, 2005, and declined redemption, concluding that funds for working capital exceeded available cash.
ThoughtWorks filed a declaratory judgment action in the Delaware Court of Chancery (the "Working Capital Decision") to determine its right to continuously exclude necessary working capital from redemption funds.
The Delaware Court of Chancery ruled that the working capital set-aside applied only in fiscal year 2005, ordering ThoughtWorks to redeem stock "to the extent funds are legally available therefor," and specifically noted that the issue of "legally available funds" under Delaware law was not decided in that action.
On July 25, 2006, a final order was entered in the Working Capital Decision.
On August 3, 2006, SVIP again demanded redemption of its Preferred Stock for $45 million.
From August 2006 through March 2010, ThoughtWorks' Board analyzed its finances quarterly and, based on legal and financial advice, redeemed Preferred Stock totaling $4.1 million on eight occasions, but also declared $0.00 available in other quarters.
On February 8, 2007, SVIP filed the current action in the Delaware Court of Chancery, seeking a declaratory judgment on the meaning of "funds legally available" and a monetary judgment.
Beginning in August 2009, ThoughtWorks sought third-party financing for a potential redemption, which resulted in a binding term sheet for $30 million (including $25 million for redemption) conditioned on all Preferred Stock being tendered, but SVIP declined, causing the commitment to expire.

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Issue:

Does the phrase "funds legally available" for preferred stock redemption in a corporate charter, under Delaware law, mean only the existence of a corporate "surplus," or does it also encompass the company's actual cash availability and its ability to continue as a going concern without being rendered insolvent by the redemption?

Opinions:

Majority - Laster, Vice Chancellor

No, the phrase "funds legally available" for preferred stock redemption under Delaware law is not equivalent to "surplus" alone; it also requires the actual availability of cash or liquid assets and that the redemption would not render the corporation insolvent or jeopardize its ability to continue as a going concern. The court rejected SVIP's argument that "funds legally available" in the Charter's redemption provision was synonymous with "surplus" under Delaware General Corporation Law (DGCL) § 160. The Vice Chancellor reasoned that "funds" in its plain meaning refers to readily available cash or cash equivalents, and "available" means accessible and ready for immediate use. The Charter's phrasing of redemption "for cash out of any funds legally available therefor" explicitly links "funds" to "cash." The court explained that while DGCL § 160 limits redemptions to surplus, it is not the sole constraint; common law has long prohibited corporations from redeeming shares if doing so would render the company insolvent or diminish its ability to pay creditors, regardless of a nominal surplus. Insolvency, in this context, includes both balance-sheet and cash-flow insolvency (inability to pay debts as they come due). The court highlighted that distributions are made from actual assets, not the accounting concept of "surplus." It found that SVIP's expert valuation, which calculated surplus based on discounted cash flow but did not assess the impact of a redemption on ThoughtWorks' going concern status or cash availability, was insufficient. The court praised ThoughtWorks' Board for its "utmost good faith" and deliberative process, which involved quarterly financial analyses, consulting with legal and financial advisors, and actively testing the market for financing, concluding that the Board responsibly managed the redemption obligation without threatening the Company's viability. This interpretation, the court noted, aligns with the settled commercial expectations of sophisticated investors who understand the limitations of mandatory redemption rights and have other protective mechanisms (like debt or control rights) at their disposal.

Analysis:

This case significantly clarifies the interpretation of "funds legally available" in preferred stock redemption clauses under Delaware law, establishing that it encompasses actual cash availability, present solvency, and the corporation's ability to continue as a going concern, not just an accounting surplus. The decision reinforces the fundamental principle of creditor protection and corporate viability over the contractual rights of preferred shareholders when cash is scarce. It provides crucial guidance for corporate boards on their fiduciary duties in assessing redemption obligations and for investors to carefully consider the limitations of preferred stock as an investment vehicle versus debt or other instruments with stronger enforcement mechanisms.

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