Maintaining the Balance of Power in Venture-Backed Startups: The Impact of Delaware’s Moelis Decision on Drafting Shareholder Rights Provisions

The Moelis Ruling

Venture capital investors with a penchant for more expansive views of preferred stockholder rights have cause for pause. While fundamentally more a commentary on drafting mechanics than anything, the ruling delivered by the Delaware Chancery Court on February 23, 2024, in West Palm Beach Firefighters’ Pension v. Moelis on its face curtails the ability of a Delaware corporation to grant stockholders governance and other major corporate powers via stockholder agreements that constrain the traditional ability of a corporation’s board of directors to run the show. Citing a “bedrock principle” of the Delaware General Corporation Law, under which “the ultimate responsibility for managing the business and affairs of a corporation falls on its board of directors,” the Moelis opinion rejected a stockholder agreement containing protective provisions and other covenants that effectively:

1. Allowed the stockholder to select the majority of board members;
2. Constrained the board to a size of eleven members or less;
3. Entitled the stockholder to name designees to a majority of seats on the board who must also be nominated as candidates by the board and recommended by the board;
4. Required the board use reasonable efforts to have the stockholder’s board nominees gain election and continue to serve on the board;
5. Mandated vacancies occupied by the stockholder’s candidate be filled with another of his designation; and
6. Required the board to appoint the stockholders’ director designees to each board committee.                                                                     

But don’t panic. Importantly, these grants of power were only invalidated as stockholder agreement provisions. The Court clarified that the same provisions are likely permissible when included in a corporation’s certificate of incorporation or bylaws. Further, since the ruling was made cumulatively on the challenged provisions, it is possible that some of the Moelis stockholder agreement’s grants of power may be valid when analyzed separately.

Best Practices Moving Forward

The broad takeaway from the recent ruling reflects a clear intention by the Delaware Chancery Court to safeguard and preserve the board’s right to govern and direct business affairs. This requires venture capital investors (and their counsel) to pay close attention when considering the where and how of covenants granting control rights to preferred stockholders in a corporation’s charter documents and stockholder agreements. More specifically, investors and practitioners should consider drafting investment documents such that stockholder veto rights over the types of corporate actions generally under the board’s purview appear in the certificate of incorporation (and not a stockholders’ agreement or side letter), and that provisions related to board structure, including any mandatory committee composition or chair appointments, appear in either the certificate of incorporation or bylaws (and not the voting agreement or investors’ rights agreement). 

As it happens, the most recent form of preferred stock investment documents published by the National Venture Capital Association (NVCA) already provide that “stockholder” veto rights in the investors’ rights agreement are technically board matters: it’s not the stockholder itself whose approval is required, just the stockholders’ board designee. Given this structure preserves corporate powers at the board level, it would appear to be permissible under Moelis. Further, the NVCA certificate of incorporation includes language indicating that this special vote requirement modifies the general “one person, one vote” rule in the standard certificate of incorporation, addressing concerns raised by the Chancery Court in the Sinchareonkul v. Fahnemann decision.

However, more aggressive investors have been known to push for some operational matters to require shareholder approval as well, often citing the theory that a different fiduciary duty standard applies. Company management has also been known to push for certain stockholder protective provisions to be moved from the certificate of incorporation to a stockholders’ agreement to avoid having the level of granted control become a matter of public record. And it is not uncommon for significant investors coming in for subsequent closings to agree to include additional governance rights they seek in a side letter rather than requiring the company to re-solicit approvals to amend existing investment documents. These approaches may not work after Moelis.  

Further, not every optional provision in the NVCA form of investors’ rights agreement may work as drafted after Moelis. For example, optional language that requires the company to establish and maintain an audit committee or compensation committee and that proscribes limits on committee composition might best be addressed going forward with amendments to bylaws (and provisions in the certificate of incorporation or bylaws themselves requiring stockholder approval for amendments of the relevant provisions).

In sum, while nothing about Moelis suggests that investors will need to give up the rights to which they have become accustomed, thoughtful drafting by counsel is now even more important than ever. Investors should discuss with counsel any more aggressive and optional terms which may impinge on the functioning of, and decision-making by, the board.