1. The Role of Venture Capital Firms With Startups
2. The Management Rights Letter and ERISA

A management rights letter is a document provided by companies to investors that gives the investors a certain level of information beyond that found in articles of incorporation or bylaws of the business.

These rights usually provide the ability to attend and observe board meetings, inspect the corporate records books, receive financial statements, and discuss matters with management of the company. Venture capital firms interested in investing in startup businesses are the most frequent recipients of a management rights letter because it may provide certain exemptions from federal regulations. 

The Role of Venture Capital Firms With Startups

Venture capital firms are important sources of funding for new corporations that need capital to get off the ground through research and development, enter into agreements with suppliers or manufacturers, or help companies market their new products. These firms play an important role in spurring innovations in information technologies by working closely with entrepreneurs and small businesses to support new technologies until they establish credibility and become attractive to a corporation or public equity firm interested in acquiring the startup’s assets.

The venture capital firm invests early, usually in exchange for shares of the young company, in the hopes of receiving a large payout when the shares can be sold off to the new investors. They are a short-term solution, filling a void created because traditional investment options, such as bank financing through loans or corporations that invest externally view the startup as too risky because there are not enough hard assets to secure the debt.

The rights that a venture capital firm receives to information about the startup aren’t really much different than those granted to any investor interested in obtaining stock in a company. However, since a venture capital firm just might be the only investor a young company attracts, and will in all likelihood request a management rights letter during negotiations, entrepreneurs should become familiar with the components of the letter.

The Management Rights Letter and ERISA

The primary reason venture capital firms negotiate a management rights letter into investment agreements with businesses is to gain exemption from the Employee Retirement Income Security Act of 1974 (ERISA).

To put is simply, venture capital firms operate through an agreement between general partners, who discover, research and make investments in companies, and limited partners who provide the funding for the investments. Limited partners generally consist of pension funds, public venture funds, endowments, hedge funds, and other large organizations holding capital acquired strictly for investment purposes. These limited partners are looking for a large return on investment, often 10 percent to 20 percent.

ERISA imposes restrictions on the investment of pension plan assets, and since many venture capital firms have limited partners that are pension plans, these restrictions often apply to venture capital firms. Specifically, pension plans that are subject to ERISA are required to follow certain rules when their funds are invested in venture funds. These include:

  • Requiring that all of the venture firm’s funds be treated as assets of the pension funds and held in trust
  • Prohibiting restrictions on certain transactions, thereby limiting any of the firm’s funds from being used for investment
  • Placing fiduciary duties on the managing partner of the firm, who is therefore subject to all applicable ERISA rules.

There are two exemptions to ERISA that venture capital firms can pursue. A venture firm’s funds can be exempt from ERISA if they limit partnership participation of ERISA benefit plans to 25 percent or less. However, this still places restrictions on the makeup of many venture capital firms.

The Venture Capital Operating Company (VCOC) exemption sets two restrictions that many firms do not deem restrictive:

  • At least 50 percent of the firm’s funds must be invested in operating companies in which the firm obtains management rights; and
  • The fund must exercise those management rights to at least one operating company a year.

Through this exemption, the venture fund essentially participates in or influences the conduct of the company. Thus the fund becomes more than an investor, but through the rights contained in the management rights letter can review financial statements and data, discuss in a management capacity the company’s activities with the company’s officers, and visit and inspect the company’s properties.

Without these ERISA exemptions provided for in the management rights letter, many great ideas that will impact the future would never come to fruition.  

To learn more about a management rights letter, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.