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The court cancelled options granted to senior officers at a startup even though they were lawfully approved

Victor Medina and his son Eitan, who invested in 2011 in Wave Guard, sued the company and its managers claiming, among other things, false representation and discrimination  Judge Danya Keret-Meir rejected most of the claim, but ruled that granting options to founders discriminates against shareholders who are non-office holders

19.11.18 | Efrat Neuman


A lawsuit conducted in recent years by two of the first investors in Wave Guard Technologies against the company and directors in the company recently ended with the cancellation of options granted to senior executives. Although Judge Danya Keret-Meir rejected most of the prosecution’s claims, she did rule that options received by senior executives, who are key shareholders in the company, should be canceled even though they were approved as required. This is because they were granted at a value that was not reasonable and at the expense of shareholders who are not officers in the company.

The plaintiffs are the investors Victor Medina, who was among other things, director general of the Finance Ministry, chairman of Mizrahi Bank and chairman of ICL, and his son, Eitan Medina. According to their claim, they are entitled to additional shares beyond those they received as part of their investment, and that before signing of the contract, they had been given false representation, and that senior company executives, the CEO David Shaul and CFO Lior Naveh, had received millions of shekels while discriminating against them.

Judge Keret-Meir of the Tel Aviv District Court, rejected most of the claims, but accepted the claim that options and commissions received by Shaul and Naveh were discriminatory compared with the other shareholders who are not employees.

Wave Guard was founded in 2009 by Shaul and Naveh. The company engages in the development of technologies in the field of cellular monitoring and positioning. In mid-2011, the plaintiffs invested about $ 500,000 in the company according to a company value of $ 4.8 million (before the investment). At the time the claim was filed, at the end of 2015, the plaintiffs held 13% of the shares, and the founders Shaul and Naveh each held approximately 19% of the shares.

In mid-2014, the company signed a deal whereby it was entitled to a payment of approximately ILS 20 million and after that money started to flow into the company. The plaintiffs argued that Shaul and Naveh had chosen to allocate themselves money from the company purse while discriminating against them, instead of using the monies cautiously or distributing an equal dividend to the shareholders.

At this stage, a retroactive salary was granted to Shaul and Naveh with an overall amount of ILS 3 million, 70% of the salary they were supposed to receive for the years 2012-2014. Commissions and options were also approved for them. Their salaries were approved by the board of directors and at the general assembly, after they had waived their salaries in the company’s tough years. Judge Keret-Maor ruled that payment in respect of wages cannot be a basis for a claim of discrimination, even if it was paid retroactively.

However, her position differed in the matter of the commissions and options they received, and she ruled that their granting was within the realms of discrimination. “There is no basis for the defendants’ claim that this was to complete the 30% gap in the salary they had waived…the allotment of additional shares is in fact at the expense of the other shareholders, and it should be considered a discriminatory allotment”.

The Judge added that if a request for a derivative claim had been filed, and there had been room to examine the business judgment exercised in making the decision, it would have been possible to determine whether it was a decision that gave unreasonable and extraordinary terms to two key shareholders in the company. According to her, primarily due to the fact that the exercise price reflected a most recent value of $ 5.5 million, there is no doubt that at the end of 2014 (the date on which the options were granted), following the ILS 10 million transaction, the value was higher still.

In light of this, she ruled that the pair should return a commission at the rate of 6% of the scope of the revenues from future transactions they had received, and options that had been allotted and not yet realized or canceled – were to be canceled and returned to the company. Options that had already been realized were, in her opinion, “lost”.

Although this is a decision written in the margins of the judgment and without too much detail, it is not marginal, and its importance is not insignificant. It is therefore puzzling that the Judge charged the plaintiffs with expenses of ILS 50,000 on the grounds that most of the claim had been rejected.

“The decision creates uncertainty”

Attorney Achai Gomeh, a partner and head of the Capital Markets, Securities and Venture Capital Department at law firm Hamburger Evron & Co. (which was not involved in the case), sees two key problems in the ruling: “First, the court’s finger was light on the trigger when it decided to cancel options granted to managers, after all the approvals required in law had been received. The fact that the court did not point to failures or flaws in the decision-making processes of the company, creates legal uncertainty regarded the options granted to founders in high-tech companies, who are in most cases are also shareholders and managers in the company,” he says.

The second problem, Gomeh says, is that the court has instigated far-reaching economic-commercial rulings relative to the degree of probability of the exercise prices embodied in options granted to founders in high-tech companies. According to Gomeh, the court ruled, without supporting evidence, that the value of a company determined by agreement in a transaction between a willing seller and a willing buyer (at the time of Medina’s investment), is extremely far away from the value of the company not long afterwards.

“In effect, in so doing, the court dismisses the basic assumption that the value derived from a genuine investment transaction expresses an estimate of the value of the company, and determines, in an almost arbitrary manner, that the value embodied in that transaction is far from reality and ‘is not realistic’ in the words of the judge”, says Gomeh. It is certainly possible that the end result in this specific dispute before the court is just, but the rulings left behind by the judgment should ignite a warning light among everyone involved in high-tech, and particularly in start-up companies”.

The company believed in its forecasts

According to the lawsuit, only about three weeks after signing the investment agreement with the plaintiffs, the company signed a deal with Eli Campo whereby he would be entitled to a package of options at an effective price that was significantly lower than the price at which they invested. Therefore, they argued, the anti-dilution clause in their agreement should be applied. The purpose of this clause is to equalize their terms with each issue conducted within 12 months, and thus allot them additional shares.

Alternatively, they demanded that additional shares should be allotted to them as a result of misrepresentations allegedly presented to them by the defendants. According to the allegations, the defendants urged them to make a quick investment that did not allow them to perform due diligence.

The lawsuit was not directed against the founders only, but also against Campo and additional shareholders, including Avraham (Miko) Gilat, who invested in the company. In the defense statement, the company, among other things, argued that it was a start-up company in its early stages at the time. Therefore, naturally enough, investment in such a company carries a large and real risk, of which the plaintiffs were well aware. It is also the reason, it claimed, that every forecast was made with the appropriate caution, even if it did not ultimately materialize. The company further argued that the plaintiffs are skilled and experience investors, who prior to signing the investment agreement were exposed to all the material and relevant information and even conducted themselves a comprehensive due diligence examination that lasted for weeks.

Judge Keret-Meir determined that Campo had provided services as a director and in return for these services, as compensation to officers, the options were allotted to him. She further determined that the anti-dilution clause agreed upon, was intended to protect against dilution in the event of investment and capital raising only – and not in the case of employee options.

The judge also found no basis for ruling that the company did not believe in the forecasts it had given, or that it had made false representations. She also ruled that even if the transactions described in documents transferred to the plaintiffs before the investment were not carried out, this should not lead to a retrospective conclusion that these deals were fabrications.

The plaintiffs claimed that prior to the investment they had been shown a presentation with an expectation of high revenues, but in practice the company’s revenues did not come close. They added that in a board meeting held five months after their investment, the forecasts had been reduced to a lower figure – without any significant event having justified the update, so there is therefore no doubt that they were given false representation before they signed the investment agreement.

Keret-Meir stated that when the investors were presented with the business plan, they knew that the company had no revenues, and that the cash consumption rate was ILS 200,000 per month, and they were also assisted by two professionals for pre-investment examinations. “I see no basis for the plaintiffs’ claim that pressure was applied on them or that they were prevented from carrying out due diligence”, she said.

The plaintiffs were represented by Attorney Dan Friedman of law firm Friedman Yunger & Co. The company was represented by Attorney Nir Rosner of Yigal Arnon & Co., and the directors, including Shaul and Naveh, were represented by Attorney Igal Longo of law firm David Longo Reznik & Co.