Here’s a situation we see often when a company is negotiating a Series A financing. They’ve gotten through diligence, completed the lengthy and difficult process of negotiating, documenting and finalizing the venture investment and the deal is ready to close. And then the investors send over something they call a “VCOC letter” or a “management rights letter.” The founders are surprised to see that it contains terms covering information, inspection and other significant management rights in their company. It says that they have to meet with the investors for “consultation and advice,” provide access to management and financial information, and, sometimes, their offices, and maybe allows the investors to attend board meetings. We’ve already negotiated these things, they think. What is this?
Let’s talk about what a management rights letter is, why the investors need it, and what you should do about it.
What is it?
A management rights letter, sometimes called a venture capital operating company (“VCOC”) letter or an “MRL” for short, is a contract between an investor and a portfolio company that grants the investor certain rights to participate in the management and operation of the portfolio company. These rights can typically include things like attending board meetings, receiving financial reports and advising the company’s management team.
Why do investors need a management rights letter?
Venture capital funds may need contractual management rights because of the money they manage. Venture capital funds take a pool of money from investors to buy ownership stakes in startups. Often one or more investors in a venture capital fund will be “benefit plan investors,” which are investors who are investing assets that are subject to (and protected by) the Employee Retirement Income Security Act (“ERISA”). ERISA imposes certain restrictions on how the benefit plan investor can invest the assets it holds in trust.
To simplify these very complex regulations, if a venture fund doesn’t have an exemption and has a limited partner that is subject to ERISA, then the fund would have to hold those assets in trust and certain transactions would be prohibited. But there is an exemption from ERISA plan assets rules for venture funds that qualify as VCOCs. To qualify as a VCOC, the fund must invest at least 50% of its assets in “venture capital investments.” An investment qualifies as a venture capital investment if it is an investment in an “operating company” and the fund obtains specific direct contractual management rights in the portfolio company. A management rights letter is one way to make sure that it has those management rights.
What should you do about it?
Because management rights are a required element for the venture funds to avoid being subject to the fiduciary duties imposed by ERISA, it typically doesn’t make sense to try to negotiate away these agreements entirely. When you get a management rights letter, you should first make sure that it’s not overly broad or burdensome.* Management rights letters are very common so they follow a predictable form and, when drafted correctly, shouldn’t impose too much of a burden on the company’s management team. Companies will also need to make sure that the management rights don’t create any CFIUS issues if the investor is located outside of the United States. Finally, companies should confirm that the management rights letter contains adequate termination provisions, so that it isn’t in force after the company goes public or exits, or if the investor is no longer an equity holder.
*The U.S. Department of Labor has issued limited guidance on what would be a sufficient level of management rights and does not require that an investor be able to direct the actions of a portfolio company.