NOTE: This is the eleventh post in our series about standard terms in early stage equity financings. These posts refer to the model Series A Term Sheet put out by the National Venture Capital Association (NVCA) and available for download here.
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If you’re following along with the NVCA term sheet, please note that we’re combining the discussion of “Management and Information Rights” and “Investor Director Approval” into one post because they both relate to the role of investors in the management of the company. We’ll return to the “Right to Maintain Proportionate Ownership” provisions (which fall between this post’s two topics in the NVCA term sheet) in our next post.
Management and Information Rights
Management and Information Rights serve to ensure that even those investors who will not have the right to appoint a member of the Company’s Board of Directors are able to obtain certain information about the operation and finances of the company. The obvious reason investors insist on receiving these rights is that they want to keep tabs on the companies in which they invest, but this not why some investors require a “Management Rights letter” from the company. Without going into too much extraneous detail, receipt of a Management Rights letter is necessary for any venture capital fund that manages assets subject to the Employee Retirement Security Act of 1974 (ERISA), which many VC funds do, because such funds must have certain management rights in their portfolio companies to avoid being subject to certain obligations under ERISA. Note that while information rights are generally dealt with in the Investor Rights Agreement itself, the Management Rights letter is actually a separate document.
Management and information rights should be non-controversial and typically are not the subject of negotiation at the term sheet stage. If the round includes a number of small investors, the company (and the lead, i.e. “Major,” investors) may want to limit who is entitled to management and information rights; though providing rights to a few additional investors is usually of minimal practical consequence to the company. The frequency and timing with which the company is required to deliver information (such as financial statements) to the investors (typically within 30-45 days following the end of each month or quarter) is also of little practical consequence because companies are often producing this information for internal purposes anyway and investors are typically lenient in enforcing the deadlines. With that said, providing for less frequent updates with greater time to deliver information is inherently better for the company. Note that any investors who have information rights should be required to agree to keep the information they receive confidential, and a standard confidentiality provision should be included in the Investor Rights Agreement.
Investor Director Approval
The Investor Director Approval provisions are, along with the Protective Provisions we discussed previously, the primary mechanism for the investors to exert control over the activities of the corporation. Approval of the investors’ director(s) is often required for matters that could materially impact the company where seeking stockholder approval would either be inappropriate (because of the subject matter) or unduly burdensome. The NVCA term sheet includes a laundry list of matters that may require approval of the investors’ director(s), but the list is by no means exhaustive. For those not following along with the NVCA term sheet, it requires approval of the investors’ director(s) for matters such as: making loans to other companies or to individuals; guaranteeing indebtedness; incurring indebtedness in excess of a set dollar amount; entering into certain transactions with company insiders (officers, directors, etc.); hiring, firing or changing the compensation of executive officers; changing the company’s principal business; selling, licensing or otherwise conveying rights to the company’s material technology or intellectual property; and entering into strategic relationships involving payments to/from the company greater than a set dollar amount.
While companies are better off minimizing the decisions requiring approval of the investors (through the Protective Provisions) or their directors, being required to obtain approval of directors is preferable to being required to obtain stockholder approval for two reasons. First, the procedure for obtaining director approval is much simpler than for obtaining stockholder approval. Second, and arguably more important, directors have certain “fiduciary duties” towards the company and its stockholders (all of them) that prohibit them from putting their own interests ahead of the company’s, whereas stockholders are almost always entitled to act selfishly. Therefore, in negotiating the Investor Director Approval provisions it is a good idea to be pragmatic: attempt to eliminate from the approval requirement any actions that should be routine, but don’t get too worked up over the need to obtain approval of the investors’ director(s) for matters that are likely to only arise periodically.