Lawsuit Over SolarCity Buyout a Distraction Tesla Doesn’t Need

Tesla‘s (NASDAQ: TSLA) $2.6 billion acquisition of SolarCity has been a disaster operationally, highlighted by the solar company’s installations plunging by 57% over the past six quarters. Tesla has laid off staff, and most SolarCity executives have left — a deeply unusual outcome for such a large acquisition.

A lawsuit brought by shareholders who questioned the acquisition’s process and justification is now moving forward after a Delaware judge refused to dismiss the case, creating an additional headache for Tesla. The judge said it was certainly plausible that Tesla CEO Elon Musk exerted control over the board of directors, and ultimately the shareholders, in getting the deal approved. When you look at the conflicts of interest that Musk and others had because of family relationships or joint roles with both companies, it’s understandable that Tesla shareholders are challenging the buyout.

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Where the disagreement arises

When Tesla agreed to buy SolarCity, we were already starting to see cracks in the solar installer’s model. Borrowing costs were rising, sales and marketing costs were out of control, and the company was failing to meet its own growth goals. And though this didn’t come to light until later, plans to manufacture its own solar panels in Buffalo, New York, weren’t going well at all.

Tesla’s board of directors should have seen all of these issues before they voted on the deal. The articles I linked to point out the flaws in the buyout — and I wrote them with publicly available information before the deal closed.

Part of what’s being challenged in the shareholder lawsuit is the conflicts the board of directors itself had. I highlighted in June 2016 that most of SolarCity’s board had ties to Tesla, and many Tesla directors, including Elon Musk, had ties back to SolarCity. Musk was chair of the SolarCity board at the time of the deal. The judge in this case is already conceding that it’s possible Musk’s “visionary” status and the ties between the two companies could call into question the deal’s propriety.

Musk had a lot to gain from the SolarCity buyout

As Elon Musk pushed for the SolarCity deal to go through, it shouldn’t be forgotten that Musk himself had a lot to gain from the deal. Not only did he own 22.2 million shares of SolarCity, worth about $460 million when SolarCity’s shares converted to Tesla, Musk personally owned about $65 million in solar bonds from SolarCity; his cousins Lyndon and Peter Rive, who co-founded SolarCity, owned another $35 million of the bonds.

Had SolarCity ultimately gone bankrupt, which was possible given its cash burn and rising debt costs, Musk would have lost over $500 million. By pushing the buyout through, he saved that value, converting most of it into more shares of the much-larger Tesla.

SolarCity may end up being a drain on Tesla

The SolarCity buyout and shareholder lawsuit matter for Tesla because it’s been an unnecessary drain on the company. Tesla doesn’t break out the solar business individually, but we know that SolarCity had nearly $1 billion in operating costs on an annualized basis just before the buyout. Now that Tesla has cut installations roughly by half, it’s safe to say the solar business is nowhere near cash flow positive.

On top of the cash drain from buying SolarCity, management has to deal with this lawsuit and any financial costs it may bring. That’s not a distraction Tesla needs as it’s trying to ramp up production of the Model 3. More than a year after the deal — which I don’t think Tesla should have taken on in the first place — SolarCity is shaping up to be a headache.

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Travis Hoium has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Tesla. The Motley Fool has a disclosure policy.

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