THE COURT IS SUPERVISING CLOSELY: THE DECISION THAT SHOULD WORRY THE STARTUPSA legal dispute that has taken place in the past year between partners of Unavoo Food Technologies Ltd. may draw a hoard of investors to Court in order to appeal the company valuation according to which many capital raising campaigns are based * “The Court has actually said that it will scrutinize the decisions of the holders of controlling interest in private companies”
02.06.20 | Efrat Noiman
When a company decides to raise capital, it is exposed to a stringent standard of review with regard to the question of whether its decision makers have a personal interest in the process (as happens in many cases) – this was raised in the decision recently granted by the Tel Aviv District Court’s Economic Department. This decision has lateral significance for the capital raising activities of private companies and the valuations whereby the capital raising is conducted – pursuant to which they are likely to be disqualified.
The precedential decision of Judge Ruth Ronen, granted at the end of March and which she upheld last week in an additional decision, was granted as part of a legal dispute that has taken place during the past year between Yuval Maimon, who developed a natural sugar substitute, and his partners in Unavoo Food Technologies Ltd, which was established at the beginning of 2017 on the basis of the development of the sweetener. The dispute has yet to be resolved; however, in the framework of the suit, Maimon asked the Court to stop the company’s capital raising campaign if conducted according to a valuation lower than $36 million – the value of the patent that he developed and transferred to the ownership of Unavoo.
Maimon’s petition follows the decision of Unavoo’s general assembly in February, regarding the financing round of $500 thousand based on a company evaluation of $700 thousand, prior to the money to be raised by this round. Maimon didn’t participate in the meeting and the Court’s assumption was that most of its partners are planning to invest in the financing. Maimon did not object to the actual investment; however, he claimed that the valuation set by his partners was arbitrary, reached without a professional opinion, with a significant dilution of those who were not in attendance.
In her decision, the Judge referred to the application of the Business Discretion Rule, whereby one must not intervene in decisions reached by the company’s board of directors as long as the decision makers acted in an informed manner, while exerting independent discretion and in good faith. However, the Judge noted that in cases in which decision makers are in a state of conflict of interest, their decision does not benefit from the immunity granted by the Business Discretion Rule; and the Court will examine the decision in its own right based on a more stringent standard of review.
Consequently, Ronen wrote, “the aforementioned rationale may also apply to the company’s decision to raise capital – whether if it was accepted by the company’s board of directors or by its shareholders in its general assembly. With regard to this decision, there is room for a more stringent standard of review when the decision makers have a personal interest.”
Who must prove that the valuation is realistic?
Maimon, who filed a suit against his partners in the company a year ago, claimed that as the one who developed the patent for a groundbreaking sugar substitute over a period of ten years, who established the company and led it from a valuation of zero to an estimated valuation of $60 million, he was dismissed from his position of CEO under unfounded pretexts, and his rights were deprived.
The defendants are Unavoo Ltd., his Israeli partner Avner Gordin (who owns 15% of the company), American partners Jack Dueck and Jeff Cohen (each of whom owns 15% of the company) and the British corporation, ED&F Man (which owns 10% of the company), which in 2017 invested $4 million in the company based on a valuation of $40 million. Maimon holds 45% of the shares.
The defendants claimed that there is no basis to the claims of deprivation of rights and that Maimon is interested in making the lives of the other shareholders and directors miserable, so he can take control of the company, or alternately, bring about its collapse and protracted legal proceedings, while they are trying to save the company.
With regard to the petition to prevent the capital raising based on the valuation that was set, the defendants claimed that the financing round was needed urgently because the company has no financing sources for its ongoing activity. Additionally, they claimed that six months earlier, they tried to raise capital based on a valuation of $1.2 million and did not succeed and that Maimon had initiated an investment based on one million dollars and did not succeed. Therefore, capital raising based on a close valuation ($700 thousand) certainly did not deprive him of his rights.
In the decision granted by Judge Ronen, she noted that when the Court examines a decision for capital raising for a private company, it also examines whether the capital raising is essential and is the best option for all the shareholders, and whether the valuation of the company for the capital raising is realistic. This is because the investment based on a valuation that is less than the company’s real valuation transfers capital from the shareholders who are not participating to those shareholders who are, with no justification. Ronen ruled that at least when there is basis for a hypothesis that the decision was reached in a situation of conflict of interests – the burden is on the decision makers to prove that the valuation reflects a realistic valuation.
The Judge wrote that with regard to the shareholders (with the exception of the British Man Corporation), they were apparently aware that Maimon would not take part in an additional investment; and consequently, they had an inherent interest in a short valuation of the company. A short valuation could enable them to ‘purchase’ another piece of the company against their additional investment at a price that does not reflect the realistic price.
After a review of the evidence presented by the parties, the Judge ruled that at this stage of the deliberation, the defendants did not shoulder the burden of proof that the value that they set was realistic, and Maimon’s claim whereby the evaluation was arbitrary has grounds. Consequently, she partially accepted his petition in this context, ruling that although the current execution of an investment is necessary for the continued existence of the company, it must be contingent upon its valuation being set according to a professional opinion or another method. This means that at this stage, no shares will be allocated for the investment, so Maimon will not be diluted. Ronen added that the defendants may also consider lending the company the sum of money that they wished to invest, or any other sum, or to seek an external investor to invest in the company.
The petition for a review was rejected
The defendant partners (with the exception of Man) filed a petition to Judge Ronen to review the decision. In this framework, they agreed to set the valuation at $1.05 million (before the money invested), which in their opinion is the last agreed upon valuation suggested by Maimon himself. Last Wednesday, the Judge rejected this petition. She noted that the assertion whereby Maimon supported the investment based on this valuation is problematic, because it may be interpreted both ways. In any case, the evidence presented by the defendants is not sufficient to change the decision.
According to Adv. Achai Gomeh, partner and director of the Capital Market and Securities Department at Hamburger Evron & Co. law firm (who was not involved in the case), the decision regarding a more stringent standard of review ruled by Ronen is relevant to many private companies, especially in the field of hi-tech. “The Court is essentially saying that it will scrutinize the decisions of authorized organs in private companies stringently with regard to decisions to conduct internal financing rounds, since there is a built-in conflict of interests among decision makers. This is not a trivial statement and it will send many deals in the industry for theoretical judicial review.”
“In addition, not only will the Court closely examine the nature of the decision to raise money and the valuation according to which the financing round will be conducted, they must also explain why the valuation they selected is fair or reflects a realistic valuation, because the burden of proof is on the organs that authorized the capital raising. In many cases, this task is almost impossible. In its ruling, the Court is implementing judicial norms that originated for public companies, which do not necessarily suit private companies and investors and their relations.”