Impact of Contractual Rights on Preferred Stock Valuations
Gilbert E. Matthews
The rights and the value of preferred stock have been the subject of several
Delaware court decisions. These decisions are particularly significant for understand-
ing the importance of contractual rights as the defining attribute affecting the valuation
of preferred stock. Directors’ fiduciary duties are primarily to common shareholders,
while obligations to preferred shareholders are primarily contractual. Preferred stocks’
contractual rights, as interpreted in these decisions, directly affects the value of the
preferred and the common. When common shareholders control the board, the impact
on the preferred can be negative. The common may be adversely impacted when
preferred shareholders, particularly venture capitalists, control the board. Some
commentators have argued that, when going-concern value is less than the preferred’s
preference, common stockholders should be entitled to the option value of their shares.
The impact of preferred stock’s contractual rights on
preferred stock (and thus common stock) valuations is the
focus of this article. It appears that this subject has been
rarely addressed in valuation literature,
analysis of courts’ views on preferred’s contractual rights
has received only limited coverage in legal articles, many
of which are cited herein.
The rights and the value of preferred stock in mergers,
recapitalizations and other valuation situations have been
the subject of several Delaware Chancery and Supreme
decisions over the years, including several
important decisions in the past decade. These decisions
are particularly signiﬁcant for understanding the impor-
tance of contractual rights as the deﬁning attribute of
In situations where the common shareholders control
the board of directors, preferred stockholders often claim
in litigation that they have received inadequate consid-
eration. The opposite often ensues when preferred
stockholders control the board, such as in venture capital
(VC) investments, particularly when the sale value of an
underperforming company is less than the aggregate
redemption value of the preferred shares. Some legal
commentators have criticized certain decisions in which
common shareholders received nothing when preferred
shareholders preferences exceeded going-concern value;
the commentators posited that common shareholders were
entitled to option value.
Directors Duties to Preferred Shareholders Are
Directors’ ﬁduciary duties are primarily to common
shareholders, while obligations to preferred shareholders
are primarily contractual. Leo J. Strine, Jr. (then
Chancellor, subsequently Chief Justice) commented in a
2013 law journal article:
[T]he board owes no ﬁduciary duty to maximize the value of
the preferred or to favor in any way the preferred over the
common, except when contractually required. In fact, the law
suggests that when push comes to shove, the board has a
duty to prefer the common’s interests, as pure equity holders,
over any desire of the preferred for better treatment based on
some generalized expectancy that they will receive special
treatment beyond their contractual rights
The Court of Chancery explained in the same year that
the board’s duty is to maximize the value of the company
for common shareholders, not the preferred:
[T]he standard of conduct for directors requires that they
strive in good faith and on an informed basis to maximize
the value of the corporation for the beneﬁt of its residual
Gilbert E. Matthews, Chairman Emeritus and
Senior Managing Director, Sutter Securities Inc.,
San Francisco, California.
See, e.g., Neil. J. Beaton, Early Stage and Venture-Backed Companies
(New York: Wiley, 2010), Chapter 2.
In this article, the Supreme Court is the Delaware Supreme Court.
Leo E. Strine, Jr., ‘‘Pitiful Poor or Potentially Powerful Preferred?’’ 161
University of Pennsylvania Law Review (2013):2025, 2028 [footnotes
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claimants [the common shareholders], the ultimate beneﬁ-
ciaries of the ﬁrm’s value, not for the beneﬁt of its
contractual claimants [the preferred shareholders].
Directors’ contractual duties to preferred stockholders
are most commonly spelled out in the certiﬁcate of
incorporation or the certiﬁcate of designation. The Court
of Chancery stated in 1986:
[W]ith respect to matters relating to preferences or
limitations that distinguish preferred stock from common,
the duty of the corporation and its directors is essentially
contractual and the scope of the duty is appropriately deﬁned
by reference to the speciﬁc words evidencing the contract.
This decision held that directors had not breached their
duties to preferred shareholders when they elected a
course of action that potentially could have beneﬁted
common shareholders to the detriment of preferred
holders, since no contractual provision precluded such
Preferred shareholders often assert that directors who
favor common shareholders have breached their ﬁduciary
duties, but these claims are almost always rejected. Preferred
shareholders may claim their optimal portion of a merger
price only if they are not subject to contractual limitations:
[J]ust as common stockholders can challenge a dispropor-
tionate allocation of merger consideration, so too can
preferred stockholders who do not possess and are not
limited by a contractual entitlement [emphasis added].
However, if the directors act unreasonably, the court
may grant the preferred shareholders a remedy. In FLS
Holdings (1993), the Court of Chancery questioned a
board’s unexplained decision to reduce the portion of the
consideration payable to the preferred shareholders when
a transaction was renegotiated. After the acquiror’s due
diligence discovered undisclosed liabilities, it reduced its
bid, and the board allocated a substantial portion of the
price reduction to the preferred class. The Court rejected a
settlement in which the preferred were to receive no
monetary beneﬁt; it said that ‘‘the directors, although they
were elected by the common stock, owed ﬁduciary duties
to both the preferred and common stockholders, and were
obligated to treat the preferred fairly.’’
It then stated:
The [preferred’s] class claims are certainly litigable. Should
plaintiffs be successful their claims could possibly be worth
several million dollars . . . [t]hough further litigation may
well prove plaintiffs’ claims to be groundless.
Some commentators have lamented that the courts have
gone too far in favoring the interests of the common. For
example, Prof. Ben Walther wrote in 2014:
Over the past three decades, ...courts have eroded [ﬁduciary]
duties to the preferred so far that they exist in name only.
Indeed, recent opinions have suggested that the board may
even have a ﬁduciary duty to siphon valuefrom the
preferred when the opportunity arises.
On the other hand, Strine stated:
[P]referred stockholders are preferred to the extent that they
secure preferences (i.e., additional rights that may have
economic value) in their contract. To the extent preferred
stockholders fail to extract contractual preferences, they are
entitled to no better treatment than other stockholders. As
preference holders, preferred stockholders are owed the duty
the corporation owes to other contractual claimants, which is
to honor their legal rights [emphasis in original].
Words Have Consequences
In various decisions, Delaware has held that preferred
shareholders’ rights are based on the court’s interpretation
of their contractual terms in the context of the speciﬁc
transaction. The precise wording is important because
‘‘the special rights, powers, or preferences of preferred
stock must be expressed clearly and will not be presumed
For example, when a company’s charter
provided the preferred stock would be automatically
converted into common with an afﬁrmative vote of 51%
of the outstanding preferred shares, the Court of Chancery
ruled that a class of preferred stock did not have a
separate class vote on that issue even though the charter
elsewhere provided that the class had a class vote on
‘‘[a]ny agreement or action that alters or changes [the
class’s] voting or other powers, preferences, or other
special rights, privileges or restrictions.’’
In another case, a preferred shareholder challenged a
subsidiary’s purchase of the parent’s common shares,
pointing out that the certiﬁcate of incorporation stated the
corporation could not purchase any junior stock when the
preferred dividend was in arrears. The Court of Chancery
ruled that although the prohibition barred the corporation
from buying shares, the wording of the prohibition did
extend to its subsidiaries:
In re Trados Inc. Shareholder Litig., 73 A.3d 17, 40-41 (Del. Ch. 2013).
Jedwab v.MGM Grand Hotels, Inc., 509 A.2 584, 594 (Del. Ch. 1986);
aff’d, 586 A.2d 1201 (Del. 1990).
In re FLS Holdings, Inc. Shareholders Litig., 1993 WL 104562 (Del.
Ch. Apr. 21, 1993) at *4.
Ben Walther, ‘‘The Peril and Promise of Preferred Stock,’’ 39 Delaware
Journal of Corporate Law (2014):161, 164.
Strine, ‘‘Pitiful Poor or Potentially Powerful Preferred?,’’ 2027–2028.
C. Stephen Bigler and Jennifer Veet Barrett, ‘‘Words that Matter:
Considerations in Drafting Preferred Stock Provisions,’’ Business Law
Today (Jan. 2014):2.
Greenmont Capital Partners I, LP v. Mary’s Gone Crackers, Inc.,
2012 Del Ch. LEXIS 236 (Del. Ch. Sept. 28, 2012.
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Impact of Contractual Rights on Preferred Stock Valuations in Delaware
Plaintiffs advance no construction of the certiﬁcate of
incorporation that would permit me to read the word
‘‘Corporation’’ to refer to any corporation other than
Sunstates. This is hardly surprising since the language at
issue is clear in its meaning and there is nothing within the
four corners of the certiﬁcate suggesting a broader or different
interpretation. Thus, as a matter of simple contract interpre-
tation, there is no basis on which to apply the special limitation
against share repurchases to any entity other than Sunstates.
Preferred stock is entitled to its liquidation preference
in a liquidation or bankruptcy (subject to prior claims).
However, Delaware case law makes it clear that a merger
is not a liquidation and does not trigger a liquidation
unless the terms of the preferred explicitly
state otherwise. Only when the preferred’s terms
expressly provide that preferred shareholders are entitled
to their liquidation preference in the event of a merger are
the holders assured that they will receive full payment
before common shareholders get anything.
When Groove Networks merged into Microsoft in
2005, its certiﬁcate of incorporation speciﬁed that a
merger was a liquidation event. Since the aggregate
liquidation preference of the preferred classes exceeded
the amount available to the common, the Court ruled that
the preferred holders were entitled to the entire net
proceeds; the common shareholders received nothing.
In 1995, Ford Motor Company merged a subsidiary
into another of its subsidiaries and cashed out two classes
of Ford Holdings preferred stock. The certiﬁcates of
designation of the two classes differed in a manner that
led to contrasting results. Certain shareholders of each
class sought appraisal, claiming that the consideration
they received was less than fair value. The Court of
Chancery ruled that the certiﬁcate of designation for one
class clearly stated that its contractual right was to receive
its liquidation preference in a merger; since the value was
contractually ﬁxed, it was not subject to appraisal.
However, the Court ruled that the certiﬁcate for the other
class had not clearly ﬁxed the consideration to be paid
upon merger, and therefore the shareholders of that class
were entitled to an appraisal to determine fair value.
In 1998 Avatex Corp., which was in ﬁnancial
difﬁculty, attempted to merge with a subsidiary in a
transaction in which the preferred stockholders of the
troubled company would receive 73% of the common
shares in exchange for their preferred shares. The
preferred shareholders opposed the proposed recapitali-
zation and claimed that they were entitled to a class vote
that would have enabled them to block it. The Supreme
Court, reversing a Chancery decision, ruled in favor of
the preferred, basing its decision on the exact wording of
the relevant provision in the certiﬁcate:
[P]referred stockholders have the right to a class vote in a
merger where: (1) the certiﬁcate of incorporation expressly
provides such a right in the event of any ‘‘amendment,
alteration or repeal, whether by merger, consolidation or
otherwise’’ of any of the provisions of the certiﬁcate of
incorporation; (2) the certiﬁcate of incorporation that
provides protections for the preferred stock is nulliﬁed and
thereby repealed by the merger; and (3) the result of the
transaction would materially and adversely affect the rights,
preferences, privileges or voting power of those preferred
stockholders. In so holding, we distinguish prior Delaware
precedent narrowly because of the inclusion by the drafters
of the phrase, ‘‘whether by merger, consolidation or
otherwise.’’ [emphasis added]
The Court noted that its ‘‘narrow’’ ruling, enabling the
preferred shareholders to vote against the transaction to
which they objected, was driven by the speciﬁc wording
of the phrase included in the certiﬁcate.
The opposite result occurred in a 1992 case where the
preferred also claimed that they had voting rights
enabling them to block a merger. Had the preferred
shareholders been entitled to a class vote, they would
have been able to veto the transaction to protect the
preferred’s value. The Court determined that the
preferred’s protective clauses did not speciﬁcally mention
mergers and therefore the preferred had no right to vote
on the proposed transaction:
The word ‘‘merger’’ is nowhere found in the provision
governing the Series A Preferred Stock. The drafters’ failure
to express with clarity an intent to confer class voting rights
in the event of a merger suggests that they had no intention
of doing so, and weighs against adopting the plaintiffs’
broad construction of the words ‘‘or otherwise.’’
A 2004 decision similarly ruled that the preferred class
was not entitled to a vote that would have blocked the
pending transaction. When Benchmark Capital Partners
had purchased preferred stock of Juniper Financial, the
preferred’s terms included protective provisions, one of
which was a requirement that Juniper obtain Benchmark’s
consent prior to taking any action that would ‘‘materially
adversely change the rights, preferences and privileges’’
of Benchmark’s preferred stock. Several years later,
Juniper required additional ﬁnancing. The entity that
In re Sunstates Corp. S’holders Litig., 788 A.2d 530, 534 (Del. 2001)
Rothschild Int’l Corp. v. Liggett Group Inc., 463 A.2d 642, 647 (Del.
Ch. 1983): aff’d, 464 A.2d 133 (Del. 1984).
Matthews v.Groove Networks, Inc., 2005 WL 3498423 (Del. Ch. Dec.
8, 2005) at *1.
In re Appraisal of Ford Holdings, Inc. Preferred Stock, 698 A.2d 973,
978 (Del.Ch. 1997).
Elliott Assocs., L.P. v. Avatex Corp., 715 A.2d 843, 844 (Del. 1998).
Sullivan Money Management, Inc. v. FLS Holdings Inc., 1992 WL
345453 (Del Ch. Nov. 20, 1992) at *5; aff’d, 628 A.2d 84 (Del 1993).
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controlled Juniper’s board offered funds on terms that
were materially dilutive to Benchmark. To prevent
Benchmark from vetoing the transaction, Juniper pro-
posed merging a wholly-owned subsidiary into itself and,
in the merger, amended and restated its certiﬁcate of
incorporation, thereby circumventing the Benchmark
preferred’s protective provisions.
Benchmark sought to preliminarily enjoin the merger
on the grounds that Juniper had failed to obtain its
approval. Juniper asserted that Benchmark was not
entitled to a class vote because the protective provisions
did not expressly apply to mergers. In this case, the
class vote to which the plaintiffs were entitled applied
only under certain circumstances. The Court of
Chancery denied the injunction since the drafters had
not speciﬁcally included mergers in the relevant
The decision was afﬁrmed by the Supreme
ThoughtWorks, Inc., had issued convertible preferred
stock that was subject to mandatory cash redemption after
ﬁve years if an IPO had not occurred. The IPO did not
happen, and preferred shareholders demanded redemp-
tion. Any delay in redemption necessarily reduced the
present value of the preferred. The ‘‘mandatory’’
redemption was limited, however, to ‘‘funds legally
available therefor and which have not been designated
by the Board of Directors as necessary to fund the
working capital requirements of the Corporation for the
ﬁscal year of the Redemption Date.’’
The Court of
Chancery ruled that the working capital set-aside applied
only for one year,
so that the issue became the
interpretation of ‘‘legally available funds.’’ After trial,
the Court decided that the term did not merely mean
surplus in the balance sheet and that the board had
reasonably considered it to mean ‘‘funds [that] could be
used to redeem the Preferred Stock without threatening
the Company’s ability to continue as a going concern.’’
The Court ‘‘ took the opportunity to make a more
fundamental point about the ‘funds legally available’
language—that funds may be legally available without
being actually available.’’
Its ruling denying the
preferred’s claim for immediate payment was afﬁrmed
by the Supreme Court. The delay in redemption and the
continuing uncertainty of payment adversely impacted the
value of the preferred.
Unless contractually barred, preferred stockholders are
entitled to appraisal rights in Delaware, whether or not the
stock is convertible; in contrast, holders of equity-linked
securities such as convertible debt and warrants are not
entitled to appraisal.
Because the value of preferred
stock is based on its contract rights, the court must
consider the contract upon which the preferred stock’s
value was based when determining the fair value of
Appraisal rights for common and preferred stock are
subject to Delaware’s market exception. Preferred stock
has ‘‘no appraisal rights if the preferred is publicly
traded and the merger consideration is publicly traded
Thus, preferred shareholders who receive
publicly traded stock in a merger, regardless of whether
the stock they receive is preferred or common, have no
Preferred’s Appraisal Value May Be Less than
In a liquidation, payment of liquidation value or
redemption value to preferred stockholders is normally
contractually senior to any payment to common
stockholders, as are preferred dividends if they are
cumulative. However, it has long been held in Delaware
that in mergers, these preferences may not be binding,
depending on the contractual rights of the preferred as
set forth in the certiﬁcate. That preference can be
eviscerated when the certiﬁcate does not specify
precisely what the preferred shareholders are to receive
in a merger.
The Supreme Court ﬁrst permitted a restructuring that
negatively impacted a company’s preferred in 1940. A
company merged with its wholly-owned subsidiary in a
transaction where the cumulative preferred stock received
a package of common stock and new preferred stock that,
taken together, had lower dividends and a lower
economic value. The Supreme Court approved the
Benchmark Capital Partners, IV, L.P. v. Vague, 2002 WL 1732423
(Del. Ch. July 15, 2002) at *4-*5, aff’d,Benchmark Capital Partners,
IV,L.P.v.JuniperFinl.Corp., 822 A.2d 396 (Del. 2003).
SV Investment Partners, LLC v. ThoughtWorks, Inc.(‘‘ThoughtWorks
2010’’), 7 A.3d 973, 978 (Del. Ch. 2010) [quoting ThoughtWorks
charter]; aff’d, 37 A.3d 205 (Del. 2011).
ThoughtWorks, Inc. v. SV Investment Partners, LLC, 902 A.2d 745
ThoughtWorks 2010 at 989.
Charles R. Korsmo, ‘‘Venture Capital and Preferred Stock,’’ 78
Brooklyn Law Review (2013):1163, 1197 [emphasis in original].
Re convertible debt: Harff v.Kerkorian, 347 A.2d 133, 134 (Del.
1975); re warrants: Aspen Advisors LLC v. United Artists Theatre Co.,
861 A.2d 1251, 1262-64 (Del. 2004).
Shiftan v.Morgan Joseph Holdings, Inc., 57 A.3d 928, 942 (Del. Ch.
William W. Bratton and Michael L. Wachter, ‘‘A Theory of Preferred
Stock,’’ 161 University of Pennsylvania Law Review (2013):1815, 1844,
citing DEL. C. §262(b)(1)-(2).
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Impact of Contractual Rights on Preferred Stock Valuations in Delaware
[I]n a case where a merger of corporations is permitted by
the law and is accomplished in accordance with the law, the
holder of cumulative preference stock as to which dividends
have accumulated may not insist that his right to the
dividends is a ﬁxed contractual right in the nature of a debt,
in that sense vested and, therefore, secure against attack
[emphasis added]... A holder of preference shares as to
which dividends have accumulated through time is not a
creditor of the corporation in the ordinary and usual meaning
of the word; nor is he the holder of a lien as that word is
Six years after this decision, the Court of Chancery
considered the value of the preferred stock of a
manufacturing company that merged with a wholly-
owned subsidiary. The liquidation value of the preferred
stock was $100 plus $86.50 in accrued dividends. The
preferred class was converted in the restructuring into
83% of the common shares and the old common
shareholders were reduced to 17%. Some preferred
holders ﬁled for appraisal. Two of the three court
appointed independent appraisers valued the preferred at
only $90 per share on a going-concern basis, less than
half of the $186.50 preference, and the $90 valuation was
approved by the Court.
Four decades later, the Supreme Court sustained the
dismissal of plaintiffs’ claim that preferred shareholders
should have received liquidation value in an arm’s-length
We agree with the Chancellor that plaintiff’s ‘‘fairness’’
argument presumes a right of the 7% shareholders to receive
full liquidation value and does not per se raise the issue of
the intrinsic fairness of the $70 price offered at the time of
the tender offer and merger [emphasis in original].
However, even assuming arguendo that plaintiff did present
a fairness issue, it is well settled that ‘‘the stockholder is
entitled to be paid for that which has been taken from him,
viz., his proportionate interest in a going concern.’’
Moreover, the measure of ‘‘fair value’’ is not ‘‘ liquidation
value.’’ Rather, the 7% shareholders were entitled only to an
amount equal to their proportionate interests in Liggett as
determined by ‘‘all relevant factors.’’
The Supreme Court pointed out that a merger was neither
a liquidation nor a sale of assets, and that it is permissible
to eliminate minority interests in a merger, provided that
they receive fair value.
Value of Preferred Shares When Redemption Is
In the past decade, ﬁve cases have addressed whether
preferred stock should be appraised at or below redemption
value. In each of these cases, the Court of Chancery based
its decision on whether the payment of redemption value
was mandated. In four of these cases, all of which related to
out-of-the-money convertible preferred stock (shares
whose value if converted into common stock is less than
their redemption or liquidation value), the Court limited
preferred shareholders to their as-converted value.
other, the Court determined that redemption was not
speculative and held that holders of out-of-the-money
convertible preferred were entitled to redemption value.
In the 2009 Metromedia International appraisal case,
the certiﬁcate of designation provided that the convertible
preferred was entitled to receive a ﬁxed amount if the
company were liquidated. The transaction which trig-
gered the preferred’s appraisal rights was a squeeze-out
merger with a third party that had purchased control in a
tender offer. The convertible preferred holders were paid
their as-converted value in the squeeze-out even though
the liquidation value of the preferred exceeded its
conversion value. Some preferred shareholders sought
appraisal, claiming that they were entitled to liquidation
value. The Court of Chancery denied the petitioners’
claim, ruling that the transaction was not a liquidation.
The Court noted, ‘‘Unlike common stock, the value of
preferred stock is determined solely from the contract
rights conferred upon it in the certiﬁcate of designa-
It pointed out:
No event triggering the liquidation provision has occurred,
and thus to base valuation decisions on assumptions that it
did would be error [emphasis added].
None of the alternative value-adding sections of [the
company]’s certiﬁcate of designation has been triggered
and, thus, these untriggered contract rights offer no non-
speculative value upon which this Court is entitled to rely in
an appraisal proceeding. Accordingly, the sole right
available to the preferred holders in the event of merger,
as explicitly set forth in the certiﬁcate of designation, is the
Federal United Corp. v. Havender, 11 A. 2d 331, 335-36 (Del. 1940).
Root v.York Corp., 50 A.2d 522 (Del. Ch. 1946).
Rothschild Intl. Corp. v. Liggett Group Inc., 474 A.2d 133, 137 (Del.
1984), quoting Tri-Continental Corp. v. Battye, 74 A.2d 71, 72 (Del.
1950) and 8 DEL. C. § 262.
When the as-converted value is greater than redemption value,
preferred shareholders normally are able to receive the as-converted
The Supreme Court has ruled that in appraisals, ‘‘speculative elements
of value that may arise from the ‘accomplishment or expectation’ of the
merger are excluded... But elements of future value... which are known
or susceptible of proof as of the date of the merger and not the product of
speculation, may be considered.’’ Weinberger v.UOP, Inc., 457 A.2d
701, 713 (Del. 1983).
In re Appraisal of Metromedia Intl. Group, Inc., 971 A.2d 893, 900
(Del. Ch. 2009).
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Based on the preferred’s contractual rights, the preferred
shareholders were awarded an amount equal to the price
paid for the common shares into which the preferred was
convertible plus the accrued dividends that would have
been triggered by a non-consensual conversion.
In a 2010 decision where the convertible preferred
stock’s certiﬁcate of designation expressly stated that a
merger did not trigger the preferred’s liquidation
preference, the board of directors of QuadraMed
determined that the preferred shareholders should receive
their as-converted value, which not only was lower than
liquidation value but also excluded accrued dividends.
The principal holder of preferred stock sought a
preliminary injunction against the merger, arguing that
the directors had a ﬁduciary duty to pay them a larger
portion of the total consideration. The Court denied the
When, by contract, the rights of the preferred in a particular
transactional context are articulated, it is those rights that
the board must honor. To the extent that the board does so,
it need not go further and extend some unspeciﬁed
ﬁduciary beneﬁcence on the preferred at the expense of
the common. When, however,... there is no objective
contractual basis for treatment of the preferred, then the
board must act as a gap-ﬁlling agency and do its best to
fairly reconcile the competing interests of the common and
The Court noted, however, that QuadraMed’s preferred
shareholders had the right to request an appraisal.
Shortly after the cash merger, the buyer averted the
appraisal by agreeing to pay the plaintiff an incremental
amount equal to approximately two quarterly dividend
The 2012 Orchard Enterprises appraisal case arose
from a transaction in which the company was taken
private by the control shareholder, who owned all the
convertible preferred stock. The preferred’s liquidation
value was greater than its as-converted value and the
controller claimed that his preferred stock should be
valued at liquidation value, thereby reducing the amount
payable to the common. The common shareholders
petitioning for appraisal asserted they had been underpaid
because the preferred should have been valued at no more
than its conversion value. The Court reviewed the
certiﬁcate of designation and ruled for the petitioners,
noting that ‘‘the liquidation preference [in the certiﬁcate]
was only triggered by unpredictable events such as a
third-party merger, dissolution, or liquidation [emphasis
It concluded that because (i) ‘‘a corporation’s
[DCF] value equals the present value of its future cash
and (ii) ‘‘the petitioners are entitled to receive
their pro rata share of the value of Orchard as a going
the convertible preferred stock should be
valued on an as-converted basis.
The 2017 GoodCents decision reached a similar
conclusion. The convertible preferred class, which had
voting control, had a liquidation preference of approxi-
mately $73 million. GoodCents was sold in an arm’s-
length cash transaction in which the convertible preferred
shareholders (with 82% of the votes) received $57 million
and the common shareholders (with 18% of the votes)
received nothing. The preferred shareholders asserted that
they were entitled to the entire proceeds because the
amount was less than the liquidation preference. The
Court disagreed. It explained, ‘‘The Certiﬁcate of
Incorporation grants the Preferred Stockholders the right
to a class vote but not a right to the Liquidation Preference
in the case of a merger,’’
and concluded, ‘‘No part of [the
relevant] section... provides that whenever GoodCents
enters a merger, the Preferred Stockholders shall be paid
their Liquidation Preference.’’
It ruled that the common
shareholders ‘‘are entitled to their proportionate share of
the fair value of GoodCents considering the Preferred
Stock on an as-converted basis.’’
A 2019 Supreme Court decision in an unrelated case
cited GoodCents and agreed with the Chancery decision
only because the preferred shareholders had voted to
approve the transaction. The Supreme Court explained:
While we think GoodCents reached the right result, we are
not persuaded by its logic... [T]he preferred shareholders in
GoodCents held 80% of the voting power and appear to have
voted to approve the merger. By the terms of the consent-
right clause in question and by virtue of the preferred
shareholders’ ‘‘ afﬁrmative vote,’’ the corporation could
conduct a merger without making a preferential distribution
to the preferred shareholders. Thus, the result—if not the
reasoning—in GoodCents is supported by the facts in that
case... To the extent that GoodCents turns on an interpre-
tation that the [consent-right] provision cannot yield
damages in the amount of the liquidation preference even
in the absence of consent, we reject it.
LC Capital Master Fund Ltd. v. James, 990 A.2d 435, 448-49 (Del Ch.
LC Capital Master Fund Ltd. v. James, Final Order dated May 27,
In Re Appraisal of The Orchard Enterprises, Inc., 2012 Del. Ch.
LEXIS 165 (Del. Ch. July 18, 2012) at *4.
In re Appraisal of GoodCents Holdings, Inc., 2017 Del. Ch. LEXIS 98
(Del. Ch. June 7, 2017) at *16.
Leaf Invenergy Co. v. Invenergy Renewables LLC, 210 A.3d 688, 700
(Del. 2019) [footnotes omitted].
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Impact of Contractual Rights on Preferred Stock Valuations in Delaware
These four decisions were each based on the fact that
the preferred stock’s redemption rights, as set forth in
their respective certiﬁcates, had not been triggered and
that therefore the preferred shareholders were not entitled
to payment of redemption value because redemption was
not mandated. A 2012 appraisal decision in Shiftan v.
Morgan Joseph Holdings reached a different conclusion
because the redemption date for the preferred was
But for the Merger, the right of the holders of Series A
Preferred Stock would have been triggered on July 1, 2011
[six months after the Merger]; that was not a speculative
possibility, but rather a legally required mandate of the
Since the certiﬁcate of designation provided that the
trigger for redemption of the preferred was in the near
future and, importantly, the company was ﬁnancially
capable of making the payment, the Court awarded
redemption value to Morgan Joseph’s preferred stock-
Convertible Preferred May Benefit from Being
Valued on an As-Converted Basis
Castle Dental Centers was sold for cash in 2004
pursuant to an agreement that the proceeds were to be
divided between the common and the convertible
preferred on an as-converted basis. Some common
shareholders sought appraisal, pointing out that the as-
converted shares attributed to the preferred class
materially exceeded the number of authorized common
shares. The Supreme Court upheld the lower court
decision that the allocation in the contract was fair, even
though the calculation was based on shares that had not
yet been authorized.
The argument is that even if the preferred stock was validly
issued, the Hildreths’ proportionate share of Castle’s fair
value must be calculated based on the actual number of
authorized shares (18 million) instead of the hypothetical
number of common shares that would be outstanding if the
preferred stock were fully converted (219 million). This
argument fails because it assumes (without any factual or
legal underpinning) that the only permissible way to value
the preferred stock is based on its convertibility into
[T]he parties to the agreement also could have used other
metrics instead. For example, they could have ‘‘ done the
math’’ and assigned a dollar value to each share of preferred
stock (approximately $115) and achieved the same result,
irrespective of the applicable conversion formula.
The issue in this appraisal is not what mechanism the parties
to the merger agreement chose to allocate a price per share,
but what proportion of the total equity, in fairness, should
have been allocated to the common stock in this appraisal
When Going-Concern Value of Common Is
Minimal, Directors Can Favor Common
In Equity Linked Investors, L.P. v. Adams, the Court of
Chancery summarized the preferred’s predicament:
Genta, a bio-pharmaceutical company that has never made a
proﬁt, does have several promising technologies in research
and there is some ground to think that the value of products
that might be developed from those technologies could be
very great. Were that to occur, naturally, a large part of the
‘‘upside’’ gain would accrue to the beneﬁt of the common
stock, in equity the residual owners of the ﬁrm’s net cash
ﬂows... But since the current net worth of the company
would be put at risk in such an effort-or more accurately
would continue at risk—if Genta continues to try to develop
these opportunities, any loss that may eventuate will in
effect fall, not on the common stock, but on the preferred
...[T]he holders of the preferred stock [wanted to] liquidat[e]
Genta and distribut[e] most or all of its assets to the
preferred. The contractual rights of the preferred stock did
not, however, give the holders the necessary legal power to
force this course of action on the corporation.
Genta was facing bankruptcy unless it completed a
ﬁnancing transaction rapidly, and in liquidation its total
equity would have been worth less than the preferred’s
liquidation preference. Genta’s board of directors agreed
to a debt-and-warrants ﬁnancing and proposed to give the
lender a majority on its board.
A preferred stockholder ﬁled a suit challenging the
proposed transaction. The Court denied the challenge,
[T]he Genta board concluded in good faith that the
corporation’s interests were best served by a transaction
that it thought would maximize potential long-run wealth
creation and that in the circumstances, including the
potential insolvency of the company and the presence of a
$30 million liquidation preference, the board acted reason-
ably in pursuit of the highest achievable present value of the
Genta common stock, by proceeding as it did [emphasis in
Shiftan v.Morgan Joseph at 932.
Hildreth v.Castle Dental Centers, Inc., 939 A.2d 1281, 1284 (Del.
Equity Linked Investors, L.P. v. Adams, 705 A.2d 1040, 1041 (Del.
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Thus, a board controlled by common shareholders can
decide on a reasonable course of action that enhances the
upside potential of the common stock, even if that
decision adversely affects the value of the preferred stock.
When Preferred Holders Control the Board and
Going-Concern Value of Common Is Minimal, the
Common May Get Nothing
When the board is controlled by preferred shareholders
(as is customary in VC investments), ‘‘preferred-con-
trolled boards may only favor the preferred over the
common if such actions can be shown to be in the best
interests of the corporation as a whole.’’
Fried and Mira Ganor commented in 2006:
[A] preferred-controlled board does not owe a ﬁduciary
duty speciﬁcally to the common shareholders and that it has
wide discretion to beneﬁt the preferred shareholders
They further explain:
Because of the preferred shareholders’ liquidation prefer-
ences, they sometimes gain less from increases in ﬁrm value
than they lose from decreases in ﬁrm value. This effect may
cause a board dominated by preferred shareholders to choose
lower-risk, lower-value investment strategies over higher-
risk, higher-value investment strategies... [and] also affect[s]
the choice between (1) selling or dissolving the company;
and (2) maintaining the company as an independent private
Sometimes, common shareholders receive nothing due
to actions taken by a board controlled by preferred
[W]hen preferred stockholders wield control of the corpo-
ration, they can cause the sale of the corporation whenever
they wish to cash out; even if the corporation is solvent,
there are plausible growth scenarios in which the corporation
could succeed and the sale will yield no proceeds to the
In some cases where the going-concern value of a
company was less than the amount contractually due to
the preferred shareholders, Delaware has sustained
transactions where the entire going-concern value
accrued to preferred shareholders and the common
shareholders received nothing. This result ensued
whether the transaction was a recapitalization or a
When Ofﬁce Mart, which was ﬁnancially troubled,
agreed to merge with Staples, the buyer required that
the merger be subject to a 90% vote of all classes of
stock in order to assure the merger qualiﬁed for
Since a common
shareholder who was hostile to the transaction held
more than 10% of the common, Ofﬁce Mart’s board
(which was controlled by VC preferred shareholders)
facilitated a recapitalization in which certain preferred
holders exercised warrants; as a consequence, the
preferred holders collectively then owned more than
90% of the common stock.
The Court concluded in
1997 that, with or without the recapitalization, the value
of the shares issued by Staples in the merger was lower
than the contractual preference of the preferred class
and that even though the common shareholders received
nothing, the recapitalization was fair to the common
In the 2013 Trados case, ‘‘the Merger constituted a
liquidation that contractually entitled the preferred
stockholders to a liquidation preference of $57.9
Trados was sold in an arm’s-length transac-
tion for $60 million,
$7.8 million of which was paid to
management pursuant to a management incentive plan.
Trados then liquidated, paying the net proceeds of $49.2
million (after the buyer recovered $3 million from an
escrow account) to the preferred shareholders.
common shareholder sought appraisal and subsequently
ﬁled a class action alleging that the Trados directors had
breached their duty of loyalty to the common. The Court
of Chancery determined that the board’s actions had
failed to meet the fair process prong of the entire fairness
standard. However, it ruled that because the amount
received by the preferred shareholders was less than their
$57.9 million preference, the common stock had no value
and therefore the transaction was entirely fair to the
Korsmo, ‘‘Venture Capital and Preferred Stock,’’ 1185.
Jesse M. Fried and Mira Ganor, ‘‘Agency Costs of Venture Capitalist
Control in Startups,’’ 81 N.Y.U.L. Rev. 967, 990 (2006).
Strine, ‘‘Pitiful Poor or Potentially Powerful Preferred?,’’ 2026.
Orban v.Field, 1997 Del Ch. LEXIS 48 (Del. Ch. Apr. 1, 1997) at *17.
‘‘[T]he Board adjusted the conversion ratio of the Series A and B and
proportionately increase[d] the number of warrants held by the holders of
Series C preferred. [Then], the Board proportionately reduced the
exercise price of the warrants from $.75 to $.28726 in order to maintain
the total exercise price of $6.4 million. Finally, the Board authorized the
redemption of 2,089,714 shares held by Series C preferred stockholders,
on a non-pro rata basis. In doing so, the company extended sufﬁcient
consideration to the Series C holders ($3,013,995) to enable them to
exercise warrants to permit them, as a group, to hold more than 90% of
Ofﬁce Mart’s outstanding common stock. The aggregate effect of these
steps was to assure that Mr. Orban was entitled to vote less than 10% of
the company’s common stock.’’ Ibid., *23–*24 [footnotes omitted].
Ibid., *26. The value of the stock issued by Staples in the merger was
less than the preferred stock’s contractual preference of $35,062,470.
$50 million in cash and $10 million of stock in the purchaser. Ibid., 31.
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Impact of Contractual Rights on Preferred Stock Valuations in Delaware
The Court concluded that
‘‘Trados had no realistic chance of growing fast enough
to overcome the preferred stock’s existing liquidation
preference and 8% cumulative dividend.’’
In a similar decision, the Court of Chancery ruled in
2014 that despite improper actions of a board controlled
by preferred holders, common shareholders had not been
damaged by a recapitalization in which they were diluted
from 26% to 2% of the fully diluted equity.
Systems, the Court of Chancery ruled that ‘‘ the Recapi-
talization, although it was approved and implemented at a
fair price, was not entirely fair because of the Defendants’
grossly unfair dealing,’’ but it concluded that ‘‘ the
Defendants who breached their ﬁduciary duties or who
aided and abetted those breaches are not liable for
because before the recapitalization
the company’s debt exceeded the going-concern value of
the company and the entire equity had no value.
Two 2019 decisions addressed transaction in which
none the proceeds of a transaction went to the common
In the ﬁrst, Mobile Posse, a software
company, was sold for approximately 75% of the
preferred stock’s liquidation preference; its board of
directors consisted of representatives of the preferred
stockholders. A prior bid had including an earnout that, if
earned, would have given a small payment to the
common, but the buyer withdrew after due diligence.
The plaintiff alleged that the directors acted improperly
and had breached their ﬁduciary duties. The Court
rejected the defendant’s motion for summary judgment
on ﬁve of six counts, and observed that, based on the facts
alleged in the plaintiff’s complaint, ‘‘it is reasonably
conceivable the Merger was not entirely fair.’’
is awaiting trial.
In the second case, Pro Performance Sports was sold
for $40 million, all of which was paid to the preferred
shareholders. The common shareholders claimed that the
board and the VC ﬁrm that controlled the company
breached their ﬁduciary duties in approving the transac-
tion and the board should have given the common a class
vote. The Court of Chancery dismissed the plaintiffs’
claim with respect to class vote, but ruled that ‘‘ plaintiffs
have managed to sufﬁciently plead a claim for breach of
ﬁduciary duty that is not foreclosed by their contractual
Does Underwater Common Stock Have Option
Even when the current value of a company is less than
the preferred stockholders’ preference, the common stock
of a going concern normally has economic value. When a
company’s senior securities (debt and preferred stock)
have preferences greater than the value of the entire
company, the common stock has an ‘‘option value.’’
the aggregate preference of the senior securities is $100
million and the going-concern value of the entity is $95
million, the senior securities bear all the downside risk
and are limited to $100 million (plus future accruals of
interest or dividends) on the upside, while the common
would beneﬁt from any appreciation in the company’s
value above the preference of the senior securities.
Publicly traded out-of-the-money call options have value
because of the possibility that the market price of the
underlying stock may become in-the-money prior to
Similarly, the common stock of a company
has optionvalue as long as the company continues to operate;
the possibility exists, however remote, that improved
operating results could generate value for the common.
Profs. Broughman and Fried note that ‘‘even if the
VCs’ liquidation preferences exceed the sale price, the
common stock might have considerable option value at
the time of sale.’’
Prof. Walther observes, ‘‘the idea that
[Trados] common equity lacked any option value makes
little sense in a ﬁnancial market in which deep-out-the-
money, soon-to-expire stock options trade with positive
Ibid., 79. The decision commented unfavorably on Trados’ failure to
obtain a fairness opinion:
One can remain appropriately skeptical of the value of fairness
opinions while at the same time recognizing that an outside analysis
of the alternatives available to Trados would have improved the
record on fair dealing. Ibid., 65.
A law ﬁrm memorandum shortly after the Court of Chancery’s ruling
The decision also provides a reminder of the importance of obtaining
a good valuation opinion, ideally contemporaneous with the time that
an exit or sale transaction is being contemplated.
Crowell & Moring LLP (Aug. 20, 2013), available at www.crowell.com/
In re Nine Systems Corp. S’holders Litig., 2014 WL 4383127 (Del. Ch.
Sept. 4, 2014) at *17; aff’d,Fuchs v.Wren Holdings, LLC, 129 A.3d 882
Ibid., *3. Plaintiffs were ‘‘granted leave to submit a petition for
attorneys’ fees and costs.’’ Ibid., *58.
Mehta v.Mobile Posse, Inc., 2019 WL 2025231 (Del. Ch. May 5, 2019).
JJS, Ltd. v. Steelpoint CP Holdings, LLC, 2019 WL 5092896 (Del Ch.
Oct. 11, 2019) at *1. The decision does not indicate the amount of the
See Beaton, Early Stage and Venture-Backed Companies, Chapter 4.
Underwater options for publicly traded shares are routinely traded on
the Chicago Board Options Exchange, the New York Stock Exchange,
and many other exchanges.
Broughman and Fried, ‘‘Carrots and Sticks,’’ 1333.
Walther, ‘‘The Peril and Promise of Preferred Stock,’’ 211.
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Strictly speaking, of course, common equity always retains
some option value, so long as it is possible for the
company’s business to turn around and become proﬁtable...
It was not certain that [Trados] common equity would ever
regain value,but that prospect seemed to be more than a
distant and remote possibility.
Adam Katz posited in 2018:
[T]he Delaware courts in Trados and Nine Systems failed to
recognize that the controlling preferred VC stockholders
deprived common stockholders of the option to continue
operating the ﬁrm in the hopes of performance improving
[emphasis in original]. Far from a nebulous species of
damage,... ‘‘underwater’’ options akin to those seized from
common stockholders in Trados and Nine Systems can be,
and routinely are, valued by ﬁnanciers and economists.
Katz argues that ‘‘Trados and Nine Systems incorrectly
concluded that the challenged transactions inﬂicted no
damage upon common stockholders.’’
[Trados] overlooks the fact that underwater stock need not
have a greater than 50% chance of exceeding the exercise
price in order to be worth more than zero. If, hypothetically,
the Trados common shareholders had a 10% chance of
growing the ﬁrm such that the ﬁrm was worth more than the
liquidation preference, surely well-motivated directors
protecting (as is their duty under Delaware law) the common
stockholders, would deem this 10% chance valuable enough
to warrant consideration.
The Trados decision quoted a legal article that posited
that option value was eliminated on sale of a company:
‘‘[B]ecause VCs... often exit as preferred shareholders with
liquidation preferences that must be paid in full before
common shareholders receive any payout, common share-
holders may receive little (if any) payout. At the same time,
the sale eliminates any ‘option value’ (upside potential) of
the common stock.’’ [emphasis added]
It is correct that the common’s option value disappears
upon the completion of a transaction in which the preferred
receives all the proceeds. However, the Delaware appraisal
statute says, ‘‘[T]he Court shall determine the fair value of
the shares exclusive of any element of value arising from
the accomplishment or expectation of the merger or
consolidation [emphasis added].’’
Since the common’s
option value (if any) exists prior to a transaction and is
eliminated only upon the accomplishment of the transac-
tion, it might be argued that option value should be
considered in a Delaware appraisal.
On the other hand,
preferred stockholders would counter this claim by
arguing that they are entitled to the full payment of their
redemption value and that any payment to common
shareholders would be contrary to that contractual claim.
Katz notes that in most Delaware preferred stock cases, the
default rule has been that the preferred stockholders’ right to
capture value from common stockholders must be speciﬁed
in the underlying agreements,
but that the courts have ruled
differently with respect to the value of upside potential:
In the absence of terms... in the preferred contract specifying
which of the contracting parties has the right to capture this
[option] value, which party should courts assume as a
default rule has this right? In Trados and Nine Systems, the
courts effectively applied a default whereby VC-held
preferred stock has the right to capture this value, placing
the burden on common stockholders to specify this right.
For valuations either in a litigation context or in the
ordinary course of business in situations where the going
concern value of the common stock is minimal, valuation
experts should discuss with counsel whether an option
value should be attributed to the common stock and
deducted from the value of the preferred.
The appropriate valuation of preferred stock is a
function not only of the ﬁnancial terms of the preferred,
but also of its legal rights. Several Delaware decisions in
the past decade have interpreted contractual provisions to
the detriment of preferred holders. Prof. Walther wrote in
2014 that recent decisions had ‘‘mark[ed] the culmina-
tion of a long and gradual decimation of the legal rights
of preferred shareholders under Delaware corporate
However, in an underperforming company
whose board is controlled by preferred stockholders (as
is common in companies with VC investors), the
common can receive nothing when the net consideration
received in a sale of a company is less than the
preferred’s redemption value.
Ibid., 215, fn. 384.
Adam M. Katz, ‘‘Addressing the Harm to Common Stockholders in
Trados and Nine Systems,’’ 118 Columbia Law Review Online 234
(2018), available at columbialawreview.org/content/addressing-the-
harm-to-common-stockholders-in-trados-and-nine-systems/. He posits
that ‘‘even if the stock was worth nothing at the time of the challenged
transactions, the unfair dealing deprived the stock of potential future
value [emphasis in original].’’ Ibid., 247. He describes the two decisions
as ‘‘the peculiar corporate law equivalent of a burglary in which nothing
was stolen.’’ Ibid., 240.
Katz, ‘‘Addressing the Harm,’’ 264.
Trados, 49–50, quoting Brian J. Broughman and Jesse M. Fried,
‘‘Carrots and Sticks: How VCs Induce Entrepreneurial Teams to Sell
Startups,’’ 98 Cornell L. Rev. (2013):1319,1323–1324.
8 DELAWARE CODE ANNOTATED § 262 (h).
It appears that none of the plaintiffs’ counsel or their experts in Trados,
Nine Systems or Orban (Ofﬁce Mart) addressed option value, so that it is
understandable the courts did not consider option value.
This position is consistent with both Trados and Nine Systems,where
even though the preferred-controlled boards had breached their ﬁduciary
duties, the preferred stockholders received their contractual preferences
and the common was awarded no damages.
Katz, ‘‘Addressing the Harm,’’ 261–262.
Walther, ‘‘The Peril and Promise of Preferred Stock,’’ 161.
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Impact of Contractual Rights on Preferred Stock Valuations in Delaware
It is important to understand the effect on value of the
terms and provisions of the preferred stock in the relevant
certiﬁcate and the prospective interpretation of these
provisions in litigation. It is often advisable for the valuator
to seek advice of counsel. In determining the value of
preferred stock, valuators must consider the effect of the
class’s contractual rights, as well as the impact of valuation
and appraisal cases with respect to preferred stock.
Since the value of common stock is the residual value
of the company after deducting the value of senior
securities, including preferred stock, it is important to
consider the preferred stock when determining the
common’s value. If the going-concern value of the
company is less than the preferred’s preferences, the
valuator should consider whether it is appropriate to
determine the common stock’s option value.
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