This post is the eleventh in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.
In the prior ten posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, explained how liquidation preferences work, discussed the conversion rights and features of preferred stock, examined voting rights and investor protection provisions, analyzed anti-dilution provisions, looked at anti-dilution carve-outs and “pay to play” provisions, described redemption rights, and examined registration rights. In this post, we will discuss management rights and information rights.
For a sample management rights provision, see the National Venture Capital Association’s (NVCA) term sheet here. It provides that the Company will deliver a “Management Rights letter” to each investor who requests one. The NVCA also has a model management rights letter, which can be found here.
The reason venture capital funds request such a letter is to avoid becoming subject to the requirements of the Employee Retirement Income Security Act of 1974, or ERISA, and its regulations. Many institutional investors who invest in venture capital funds are pension plans, and pension plans that are subject to ERISA are required to follow certain ERISA plan asset rules. Under these rules, the plan’s assets must be held in trust and the plan’s managers have fiduciary duties and are prohibited by ERISA and the Internal Revenue Code from engaging in certain transactions. If the plan invests in a venture capital fund, then generally the fund’s assets are treated as the plan’s assets and the managing partner of the venture fund is treated as an ERISA fiduciary (and therefore subject to all of the applicable ERISA rules). A venture capital fund can avoid these rules only by qualifying for an exemption from the ERISA plan asset rules. One such exemption under Department of Labor regulations provides that if the fund is a “venture capital operating company,” it is deemed not to hold ERISA plan assets.
Under the regulations, a venture capital fund is a “venture capital operating company” if at least 50% of its assets are invested in venture capital investments. These include investments in operating companies (other than venture capital operating companies) as to which the fund obtains “management rights.” In addition, to qualify for the exemption, the venture fund must actually exercise these management rights with respect to at least one operating company a year. “Management rights” are defined as “contractual rights directly between the investor and an operating company to substantially participate in, or substantially influence the conduct of, the management of the operating company.” A management rights letter, then, is intended to create these contractual rights so that the venture capital fund may legitimately avail itself of the exemption from plan asset rules described above.
In opinions, the DOL has stated that whether specific rights qualify as “management rights” is a question of fact that depends on the particular facts and circumstances. The DOL has implied that the right to appoint a director or have a representative serve as an officer would be sufficient, but not necessary, and other sets of rights may suffice. DOL guidance indicates that the following set of rights set forth in a written agreement constitutes “management rights,” as long as there is no limitation on the ability to exercise any of them, so they may be thought of as a safe harbor of sorts for the venture capital fund:
- the right to receive quarterly financial statements;
- the right to receive annual audited financial statements;
- the right to receive any periodic reports required by securities laws;
- the right to receive documents, reports, financial data, and other information as reasonably requested;
- the right to visit and inspect the company’s properties, including books of account;
- the right to discuss company’s affairs, finances, and accounts with the officers; and
- the right to consult with and advise management on all matters relating to the company’s operation.
The management rights may not exist “only as a matter of form”; they must be exercised regularly and the venture capital operating company must devote effort to their exercise. However, the portfolio company management does not have to comply with the venture capital operating company’s advice or compensate it for its management activities.
The NVCA’s model management rights letter includes the following rights:
- If the investor is not represented on the board, the right to advise management on significant issues and to have regular meetings with management;
- The right to access the company’s books and records, inspect its facilities, and request information; and
- If the investor is not represented on the board, the right to receive material the company provides to directors and to address the board about significant business issues.
Some of the rights listed in the management rights letter may overlap with rights granted to investors generally, such as the information rights discussed below. Under ERISA regulations, however, the venture capital investor must have its own specific contractual rights; rights that all of the investors happen to share do not qualify.
The letter will generally provide that these rights terminate when the investor no longer holds shares, when the company’s securities are sold in a registered public offering, or upon a merger or consolidation of the company.
Management rights letters are common practice in U.S. venture capital deals and are not usually heavily negotiated. However, founders should pay attention to the specific rights requested and make sure they will not be overly burdensome. As noted above, not all of the rights set forth in the DOL guidance need to be granted to exempt the venture fund from the ERISA rules.
The NVCA’s term sheet also includes a sample information rights provision. This provision grants investors access to the company’s facilities and personnel as well as the right to receive certain reports from time to time. The provision can limit these rights to only certain investors, such as major investors who hold at least a certain number of shares of preferred stock or those who are not competitors of the company. The provision contains limits to make it less burdensome to the company: investors can access the company’s facilities and personnel only during normal business hours and with reasonable advance notice. The reports comprise annual and quarterly financial statements as well as a budget for the next year’s monthly revenues, expenses, and cash position. They could also include monthly financial statements and a quarterly updated cap table, and other information as negotiated by the parties.
Information rights are customary in venture capital deals. However, as with management rights, founders should pay attention to the specific rights requested and make sure they will not be overly burdensome.
In the next post, we’ll discuss preemptive rights.
© 2014 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.