Date: Aug 16, 1996 Source:
One recent case decided by the Massachusetts Superior Court calls into question the enforceability of warrants in a venture investment transaction. In Zero Stage Capital, Inc. et al. v. Harvard Clinical Technology, Inc., the Court was called upon to determine whether Harvard Clinical should (a) be required to honor a “detachable” warrant to purchase its common stock as an independent obligation issued as consideration for a bridge loan or (b) be relieved from the obligation because the warrant was conditioned upon an ultimate investment that never occurred.
In early 1996, Harvard Clinical received FDA approval to market a dual-syringe medical pump device that enables the computation and intravenous administration of multiple dosages of medication. Harvard Clinical sought an investment of $1,000,000 from Zero Stage Capital, Inc. and the Massachusetts Technology Development Corporation. In May 1996, the investors proposed a $1,000,000 investment in exchange for preferred stock, setting a projected closing date of August 9, 1996, subject to completion of due diligence and definitive agreements. The investors also expressed a willingness to consider making a “bridge loan” to satisfy the company’s needs for immediate cash until the investment transaction could be completed.
The terms of the proposed bridge financing called for a demand loan of $250,000 repayable with interest at 10% per annum. The terms also provided that “(1) Note and accrued interest will convert on terms and conditions of a financing totaling $1.0 Million; and (2) Harvard [Clinical] will give [each of the investors] a detachable warrant to purchase 2,000 shares of common stock at $0.01 per share.” A detachable warrant is basically an option to purchase stock upon agreed terms and is generally believed to create a separate right and obligation, independent from the transaction from which it arises. Warrants are used extensively in venture transactions as an acceptable form of compensation to investors or lenders for the high risk of financial accommodations provided to a company.
Harvard Clinical agreed to the bridge financing in late July 1996 and executed customary loan documents, but the warrants were not prepared or executed at that time. The parties then undertook a long due diligence process and negotiation of the definitive investment agreements. A new projected closing date for mid-September came and went, with a new projected closing date set for December 13. Harvard Clinical and the investors worked to complete due diligence and the necessary documentation of the transaction by December 13. On December 12, a representative of the investors met with management of Harvard Clinical to execute the warrants that had been discussed at the time of the bridge financing. Later that same day, the investors advised Harvard Clinical that the closing would not proceed on the following day due to a number of unfinished tasks. Thereafter negotiations between the parties trailed off.
In the spring of 1997, Harvard Clinical found another source of capital and repaid the $250,000 bridge loan, with all accrued interest. After repayment of the bridge loan, the investors attempted to exercise their rights under the warrants. Harvard Clinical refused to honor the warrants, asserting that the warrants were canceled because they were intended to be coupled with the aborted $1 Million investment, and were not an independent obligation of Harvard Clinical granted in consideration of the bridge loan.
In Zero Capital, the Court deemed the contracts to be ambiguous as to the nature of “detachable” warrants. The Court placed much weight on the grammatical construction of the relevant sections of the agreements, finding that the use of the word “advance” in the context of the $250,000 loan suggested the amount was to be part of the ultimate $1 Million investment and not a separate transaction. The Court made a tortured grammatical determination that the structure of the above-quoted subparagraphs (1) and (2) constituted “coordinated clauses in one elongated compound sentence joined by a semicolon and the conjunction “and” so as to merge them into a logically single transaction.” The Court also found that the delay in the preparation and execution of the warrants suggested their connection with the ultimate investment.
Thus, the Court held that the grant and validity of the purportedly “detachable” warrants were conditioned upon the consummation of the proposed $1 Million investment and were not independent obligations of Harvard Clinical created as consideration for the bridge loan. Such a result is difficult to reconcile with the long established course of dealing of venture investors in the marketplace, who rarely act as simple interest lenders to businesses. While the Court’s decision acknowledges the general use and acceptability of detachable warrants in venture investment transactions, the Court found that the actual terms of the agreement in the Harvard Clinical transaction did not justify that the warrants be given the customary treatment of “detachable” warrants.
This case is instructive of the care that must be taken to document the deal in a timely manner and in a way that clearly describes the rights and obligations of the parties at each stage of the transaction.
