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I'm trying to understand the details behind private equity investment and especially seed/pre-seed rounds. I am based in the UK, so the laws can be different elsewhere, but I would love to hear general consensus.

Are there any guards against a startup raising multiple rounds to develop an IP and go default and sell off the IP to a "friend" company?

For example, Startup A raises 4 mil investor money and 1 mil debt in 5 years to work on a high tech project, after the rounds, the founders own 51%, other shareholders own 49%. Eventually, founders decide to sell off the assets or be "acquired" by Startup B for 0.5mil which all goes to cover the debt. So the shareholders get nothing from the sale.

Now Startup B gets 5mil R&D output for 0.5mil. A great bargain. Could Startup A founders be also shareholders in Startup B? So by even though Startup A founders get nothing from the sale as such, they might get benefit from Startup B acquiring the IP. So they kind of conned the 49% shareholders of Startup A.

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The directors of Startup A have seven key duties.

  • Duty to act within powers
  • Duty to promote the success of the company
  • Duty to exercise independent judgment
  • Duty to exercise reasonable care, skill and diligence
  • Duty to avoid conflicts of interest
  • Duty not to accept benefits from third parties
  • Duty to declare interest in proposed transaction or arrangement

If the sale was an attempt to plunder the resources of A in order to enrich themselves as investors in B, the sale would violate most of these duties but most obviously the duty to exercise reasonable care and to avoid conflicts of interest. The minority investors would have an incredibly solid case if they were defrauded by the directors of A in such a blatant way.

On the other hand, if the sale was an arm's length transaction, it is entirely possible that it would be legitimate. It is entirely possible that A would spend $5 million developing a bunch of IP that turns out to only be worth $500,000. It would be entirely reasonable for the directors of A to discover this fact and decide that the most prudent decision was to sell of the IP, pay off the debt, and shut down the company because they didn't believe that the alternative was running up additional debt/ raising additional funds that they wouldn't be able to repay. Investing in early stage companies is risky after all-- sometimes ideas turn out to be not quite as profitable as you had hoped.

Whether it was an arm's length transaction or an attempt to plunder A to enrich the majority shareholders at the expense of the minority would require a judge to look at the actual circumstances. If A and B are largely owned by different sets of people, the directors of A that owned shares in B all declared their interest (and recused themselves from the vote if their stake was large) and there are a ton of emails going back months where the directors are all talking about whether or not there is a path to profitability, that would very much look like a reasonable transaction. If the spouses of the majority shareholders of A own 100% of B, they all hid their interest, and there are a bunch of emails where they talked about how they managed to fleece the 49% shareholders of A, the judge would find the transaction illegitimate.

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    @TCooper - The "obviously guilty" case is intended to be a bit unlikely with overwhelming evidence. Reality, of course, is that cases generally aren't perfect. Usually there is at least a colorable argument that the directors were behaving lawfully and the judge has to weigh the evidence to try to differentiate a potentially bad business decision from actual malfiesance. Sep 1 at 20:05
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    @TCooper In practice, people who engage in crimes tend to have "practice" with previous similar crimes. And they usually get away with the previous crimes, so reasonably think they are unlikely to get caught with their next crime, because most crime doesn't get the criminal caught. People leaving email records of what crime they are committing, or search engine records, or what have you happens all the time, because their previous N crimes they did that they didn't get caught. And email is really useful to get stuff done.
    – Yakk
    Sep 1 at 21:06
  • Along with the important task of enforcing the directors' duties, minority shareholders have their own set of rights: gannons.co.uk/shareholder-rights/minority-shareholders Sep 1 at 23:31
  • In the UK it's extremely easy to check on past directorships find-and-update.company-information.service.gov.uk so even if you got away with it, it would likely make it difficult to fund your next business venture.
    – grahamj42
    Sep 2 at 11:14
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A VC who only has a minority stake will also have a shareholder agreement that limits what the company can do with its assets without the VC's permission. And/or have a class of stock with certain rights, even though a minority of the general voting shares. It might require a separate vote of each class to approve certain corporate actions.

And they will contractually require the founders not to go into a competing business within X years, and other terms the VC sees as necessary.

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