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Idealab, a Pasadena-based start-up incubator, sold shares of its Series D preferred stock to several venture capitalists for several hundred million dollars. Ultimately, many of those shareholders became disenchanted with Idealab's management and filed a lawsuit to involuntarily dissolve the company.
Since 1947 under California law, minority shareholders holding at least one-third of the outstanding shares (calculated by assuming conversion of any preferred shares convertible into common shares) could generally petition a court to involuntarily dissolve the corporation1. Shareholders holding at least one-third of the outstanding common shares could also do so. In 1977, the California Legislature enacted the General Corporations Law which, among other things, expanded the authority to initiate the involuntary dissolution of a corporation. Thus, for example, Section 1800 of the Corporations Code permits persons authorized in the corporation's articles of incorporation to initiate involuntary dissolution proceedings.
However, the plaintiffs in the Idealab action collectively held less than one-third of all of the outstanding shares.2 Idealab's articles of incorporation (as amended) did not specifically give the Series D shareholders (or any portion of them) the right to liquidate the company. The trial court therefore ruled that the plaintiffs had no standing to petition for involuntary dissolution.
In Kline Hawkes California SBIC, L.P. v. Superior Court, __ Cal.App.4th __ (2004), the Court of Appeal reversed the trial court's ruling. In a case of first impression, the appellate court held that under subdivision (a)(2)(iii) of Section 1800, a shareholder or shareholders who hold shares representing not less than one-third of the equity of a corporation may sue to involuntarily dissolve it. Subdivision (a)(2)(iii) provides that a verified complaint for involuntary dissolution may be filed by a shareholder or shareholders who hold shares not representing less than 331/3% of "(iii) the equity of the corporation" (exclusive of certain shares).
The Series D stock of Idealab had a liquidation preference of $100, meaning that for each share of Series D stock owned the shareholder would be entitled to receive $100 upon liquidation of the company and distribution of any excess of its assets over its liabilities, in priority to shares of common stock or other junior class or series of preferred shares. (The liquidation preference includes any cumulative dividends accrued and unpaid.) Because the liquidation preference is a measure of the shareholders' entitlement to equity, the court in Kline Hawkes held it must be taken into account in calculating whether the one-third threshold of Section 1800 is met.
Many start-ups negotiating deal terms with venture capitalists do not realize the full import of the liquidation preference (and the related dividend preference). Under Kline Hawkes, a relatively small number of shareholders may have a preferential right not simply upon liquidation, but a preferential right to force liquidation.
1 In Buss v. J.O. Martin Co., 241 Cal..App.2nd 123, 130 (1966), the Court of Appeal construed this requirement to mean that any distinctions in classes of stock, or their respective rights and preferences, were to be disregarded for purposes of calculating what constitutes one-third of the outstanding shares.
2 Of course, they also held less than one-third of the outstanding common stock.
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