Just when you think you’re done with all the legal and financial paperwork after your first fundraise, an investor can tack on yet another request: a management rights letter. While not every investor will ask for one, it’s important to be prepared if yours does. In this post, we’ll run through what this document entails, answer some related questions, and explain why some investors will request one in the first place.
What goes into the management rights letter?
A management rights letter typically contains provisions that grant an investor certain privileges of company oversight. These include the right to:
- Attend and observe board meetings
- Inspect corporate books and records
- Receive copies of financial statements
- Discuss matters and consult with the management of the company
Why do your investors want this?
A management rights letter also allows investors to ensure their exemption from certain federal regulations under the Employee Retirement Income Security Act of 1974 (ERISA).
ERISA is a federal law that limits the management of pension plan assets. When a pension plan invests in a venture capital fund, that fund becomes subject to ERISA requirements. Under ERISA, there are strict restrictions on how benefit plan assets can be invested, and a litany of regulations apply to such assets. For a full list of these provisions, visit the Department of Labor website.
Because complying with ERISA can be cumbersome, many VC firms look to avail themselves of exemptions.
How does a Management Rights Letter provide exemption from ERISA?
There are two types of ERISA exemptions that a VC can qualify for. Under the first type, the fund does not have to comply if it restricts ERISA benefit plans to holding under 25% of the value of any class of equity interest in the fund. However, investors often find this 25% cap overly restrictive, and thus avail themselves of the second exemption, known as the VCOC (venture capital operating company) exemption.
For a firm to qualify as a VCOC, two things must be true:
- At least half of all assets under management at the firm must be invested in operating companies, i.e., businesses that make or sell a good or service.
- The firm must, in the ordinary course of business, exercise management rights for at least one operating company every 12 months.
By having you sign a management rights letter, and taking on those oversight privileges, an investor can become a VCOC and earn their ERISA exemption.
Need help with the flurry of documents that you’re dealing with during your financing? Let’s chat.