Investor Rights Agreement: Everything You Need to Know
An investor rights agreement (IRA) is a typical document negotiated between a venture capitalist (VC) and other concerns providing capital financing to a startup company. 3 min read
An investor rights agreement (IRA) is a typical document negotiated between a venture capitalist (VC) and other concerns providing capital financing to a startup company. It provides the rights and privileges afforded these new stockholders in the company. They typically cover subjects such as stock registration rights, “rights of first refusal” or “pre-emptive rights” when additional shares are offered to the public, and other rights that sweeten the deal for the VC.
Investors obtaining only a minority interest in a closely held corporation desire this form of agreement to protect their interest. Corporations grant these rights because they receive a capital investment that might otherwise not materialize and want the deal as attractive as possible to the investors.
Features of an Investor Rights Agreement
The most common rights usually granted to investors by a company are:
- Liquidity of stock: The VC requires that the stock be registered with the SEC as part of an initial public offering, which means the stock can be traded on the stock market (usually after what is called a lock-up period).
- Right to receive corporate reports: These reports include financial and management reports, and other periodic updates from the company.
- Participation rights: Typical examples of these rights include rights of first refusal and pre-emptive rights that protect the investor’s percentage of ownership of the company.
Other rights can be negotiated, and usually reflect the amount of control the startup is willing to grant in return for the investment. These include:
- Board membership: Startups can agree to allow the VC to be represented on the board of directors or to serve on board committees with the authority to approve extra-budgetary financial expenditures.
- Dividend rights and calculations: VCs are allotted preferred stock as part of their investment, and a feature of these stocks is the priority the holder receives in terms of dividend payments and anti-dilution protection.
- Indemnification and expenses: An indemnification clause provides VCs additional protection from liability due to board decisions, and expenses are often paid because VCs may have to travel to attend meetings in the location of the startup.
- Observer rights: The startup provides the VC with notice of and the opportunity to attend all board and committee meetings.
- Inspection rights: The investor is given the authority to inspect the startup’s corporate record books, and discuss finances and accounts with the officers.
- Provisions to address unique concerns: In the event unexpected expenditures or board action is required, the VC is accorded a wide range of rights to influence or offer consent in these situations.
The registration right provision is often one of the most important components in an investor rights agreement to investors. It gives the investor the authority to require the startup to list the shares publicly on the stock market. This allows the investor to capitalize on the investment by selling the shares to other parties.
It is an issue that a privately held company should not approach lightly if it wants to retain complete ownership of the company. Granting a registration right may be necessary to raise capital, but a registration right forces the company to become a publicly traded corporation.
In most cases, it is the majority block of shareholders that make the determination of if and when the company will go public, and the minority block has no say in the matter. However, even a minority shareholder can force this action if they have been granted registration rights.
There are reasons the startup should guard against granting these rights.
- The IPO filing process can be expensive and drain funds that would be better allocated to operations and research and development.
- Employees must devote time to collecting and preparing documents that are required by the SEC for IPOs rather than running the business.
- Market conditions may not be optimal and the startup may not get an adequate price for each share.
Even if an investor demands that a registration be included in the investor rights agreement, there are steps a startup can take to limit the impact they may have on the company. It is possible to prevent a registration right from being exercised before a negotiated future date when the company may be in better financial shape. The company can insist that the registration right be piggybacked onto existing plans for a future IPO at the company’s convenience.
While an investor rights letter is a typical component of the early capitalization of a young company, care should be taken that the startup does not relinquish important facets of control.
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