In the world of venture capital investment, there certainly is no shortage of paperwork and documentation to accompany every financing. Term sheets, stock purchase agreements, convertible notes, stockholders agreements and charter amendments are all legal documents that spring to mind when discussing early stage investment, and many have all been covered in some level of detail by previous posts on this site. One document that often takes entrepreneurs by surprise when they receive their first investment from an established venture capital fund is the management rights letter.
A management rights letter is not a document to be feared by entrepreneurs. Rather, it is simply a mechanism by which venture capital investors attempt to ensure their exemption from certain federal regulations under the Employee Retirement Income Security Act of 1974 (“ERISA”). Absent an exemption, if a pension plan subject to ERISA is a limited partner in a venture fund (which can often be the case), then all of the fund’s assets can be subject to onerous regulations that place certain fiduciary duties on fund managers and can otherwise limit a fund manager’s ability to operate.
However, if a venture fund qualifies as a “venture capital operating company” (VCOC) it is exempt from these regulations. This is what drives a venture capital investor’s request for certain management rights and the management rights letter. If the venture fund receives contractual rights that allow it to substantially participate in, or substantially influence the conduct of, the management of the company, then the investment can qualify as a “venture capital investment.” If at least 50% of the fund’s assets are invested in venture capital investments, the fund will qualify as a VCOC.
The management rights given to the investor by virtue of the letter generally include the ability to attend and observe board meetings, contact and consult with members of the company’s management, inspect the company’s books and records, and receive quarterly and annual financial statements. These likely won’t differ much from the general board, observer and inspection rights that most significant investors would negotiate in a stockholders agreement, investors’ rights agreement or some other mechanism. However, a prudent entrepreneur should be familiar with what a management rights letter generally looks like, in the event that one comes across the table when negotiating their next round of financing.
A typical management rights letter will generally include an introduction paragraph with language similar to the following:
“Ladies and Gentlemen:
You have requested that [Company], a Delaware corporation, grant certain management rights to [Investor] so that the purchase by the Investor of shares of the Company’s Series A Preferred Stock, par value $0.001 per share (the ”Stock”) pursuant to the Series A Preferred Stock Purchase Agreement, dated as of the date hereof among the Company, the Investor and the other parties thereto, as such agreement may be amended, supplemented or otherwise modified from time to time (the “Purchase Agreement”), from the Company, may qualify as a “venture capital investment” as described in clause (d)(3)(i) of the U.S. Department of Labor Regulations § 2510.3-101 (the “DOL Regulation”). This letter will confirm our agreement that the Investor will be entitled to the contractual management rights enumerated below and, in addition, will be entitled to all rights specifically provided to “Holders” pursuant to the Company’s Investors’ Rights Agreement as in effect as of the date hereof (the “Investors’ Rights Agreement”), including, without limitation, the right to receive financial information and inspection rights (all such information, inspection, management and other rights hereinafter collectively referred to as “Management Rights”):”
The letter normally then goes on to list the various management rights afforded to the investor, which, as indicated above, typically include inspection rights, the right to visit the company’s properties, the right to observe board meetings (if the investor doesn’t already have a director on the board), the right to consult with and advise management, and the right to receive copies of the company’s quarterly and annual financial statements.
This letter gives the venture capital investor the contractual evidence they need to prove that they substantially influence and participate in the management of the company, and thus aides them in obtaining the ERISA exemption discussed above. It is important to have counsel review any documents proposed by potential investors in connection with a financing, and the management rights letter is no exception. However, hopefully the next time you see one come across the table, it won’t take you by surprise, and you’ll be able to recognize its purpose and the value it provides to your future venture capital investors.