Vernon v. Cuomo: Lessons for When Things Start to Come Apart in a Startup

When things start to go awry in a startup company, they can go very wrong indeed.  The situation that gave rise to the North Carolina decision in Vernon v. Cuomo, Case No. 06CVS8416 (2009 N.C. B. C. 6 Mar. 17, 2009) and (2010 N.C. B. C. 5 Mar. 15, 2010), provides a case in point.  In March 2009, the North Carolina Business Court found that a group of majority shareholders who were also Board members of a corporation breached their fiduciary duties to such an extent that the court ruled that the corporation should be dissolved for abusive management — a rare circumstance – but gave the majority  shareholders the option of avoiding dissolution by buying out the shareholdings of the plaintiff minority shareholders at a judicially determined fair valuation.  Because the majority shareholders opted for buying out the minority shareholders, the court’s proceedings entered a valuation phase and that valuation decision was issued last month.  (A link to both the March 2009 decision on liability and the March 2010 decision on valuation is provided below.)

Liability Phase

Reading the facts as summarized by the court in the 2009 decision makes for interesting reading about the various “dysfunctions” that sometimes arise in any closely held company where stress is high amd resources are scarce but opportunity seems just around the next corner.  The plaintiffs had varying shareholdings in an early stage medical products company, called TriboFilm.  The honeymoon period among all the shareholders came to a gradual end and the two plaintiffs, holding between them about 40.4% of the equity in TriboFilm, found themselves on the outs. Once that happened, the majority proceeded to terminate the employment of the two minority shareholders (protected by the business judgment rule), authorize higher than usual salaries for themselves (problematic because of self dealing), caused the articles of incorporation to be amended to authorize significantly more shares without full disclosure of a legitimate business reason for this and then — you could see this one coming – issuing themselves sufficient shares ostensibly in forgiveness of accrued salaries, with the result that the plaintiffs’ equity percentage was diluted from 40.4% down to 4.8%.  The court found this series of actions to be self dealing to such a degree that they amounted to a breach of fiduciary duties for which the only remedy was a court-ordered dissolution of TriboFilm or a forced redemption of the minority’s original equity percentage.

Valuation Phase

In the valuation phase of the proceedings, the court struggled with how to value the illiquid shares in a company that was closely held and that had not yet started to generate any appreciable revenues, notwithstanding its potentially very valuable portfolio of intellectual property.  A court-appointed third party valuation expert rendered its opinion to the court after some difficulty in extracting necessary information from the defendants.   The court’s opinion on valuation is notable for walking through various approaches in valuing an early stage business for which intangible assets (intellectual property rights) that have not yet been commercialized in any substantial manner.  The court ultimately came to a sort of Solomonic resolution by awarding to each plaintiff a defined amount for a portion of the value plus an ongoing royalty on future earnings, thereby avoiding a windfall payment either way and also to allow participation by the minority shareholders in future upside potential that was merely speculative at present.

Copy of Initial Opinion in Vernon v. Cuomo (Liability Phase):  Vernon v. Cuomo (Phase 1 Opinion 2009)

Copy of Second  Opinion in Vernon v. Cuomo (Valuation Phase):  Vernon v. Cuomo (Phase 2 Opinion 2010)

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