What is a management rights letter and why is my investor asking for it?

Guest post by DLA Piper

What are they?

A letter agreement between a company and an investing venture capital fund which provides the fund with certain “management rights” that allow it to substantially participate in, or substantially influence the conduct of, the management of the portfolio company.

Why are they important?

A management rights letter is critical for any venture capital fund that is seeking to rely upon the venture capital operating company (VCOC) exemption in order to avoid its assets from being subject to the Employee Retirement Income Security Act of 1974 (ERISA) and the onerous requirements that would be imposed thereunder (which would include managers of the fund becoming personal fiduciaries under ERISA with respect to any private pension plans that invest in the fund and becoming subject to a set of strict prohibited transaction rules and conflict of interest and self-dealing issues as a result of the fund manager’s receipt of performance fees in the form of its carried interest).

As background, private pension plans constitute a meaningful percentage of the investors in venture capital funds. The assets of such pension plans are subject to ERISA. When a venture capital fund takes in investors who are themselves subject to ERISA, the fund will want to avoid the assets of the fund from also becoming subject to ERISA. There are two exemptions that a venture capital fund can seek to rely upon in order to avoid such an outcome:

1. The Not Significant Participation Exemption (ie, the 25 percent test)

  • If less than 25 percent of each class of equity interests of the venture capital fund (and a fund typically only has one class of equity interest) is held by investors who are subject to ERISA, then the assets of the fund will not be subject to ERISA.
  • In determining whether the 25 percent threshold has been surpassed, investments by public pension plans and non-US pension plans are not counted towards the threshold.

2. The VCOC Exemption

  •  If the venture capital fund qualifies as a VCOC, then the assets of the fund will not be subject to ERISA.
  • In order to qualify as a VCOC:
    • at least 50 percent of the fund’s assets must be invested in operating companies in which the fund has direct contractual management rights (which is where the management rights letter comes into play) and
    • the fund must exercise such management rights with respect to at least one operating company that it holds an investment in
  • The 50 percent requirement must be met on the date the venture capital fund makes its first investment.
  • The securing of a management rights letter by a venture capital fund is critical in that it is the means through which the fund has direct contractual management rights in its underlying portfolio companies.

What should they contain?

A management rights letter should secure as many of the following rights as possible for the investing venture capital fund:

  • The right to appoint one or more directors to the board of the portfolio company
  • The right to regularly informally consult with and advise the management team of the portfolio company
  • The right to receive quarterly and annual financial statements of the portfolio company, including the annual auditor’s report
  • The right to examine the books and records of the portfolio company
  • The right to receive copies of all documents, reports, financial data and other information that the fund may reasonably request and
  • The right to appoint a person to serve as the corporate officer of the portfolio company

Potential traps

  • Rights that a venture capital fund secures and shares with other investors do not count as management rights for purposes of meeting the VCOC exemption (ie, the rights must be individual to the fund). Thus parallel funds or related co-investment funds should each obtain separate management rights letters.
  • Portfolio company investments, which are made by a venture capital fund indirectly through a special purpose vehicle, which is not wholly owned by such fund can be an issue in situations where the special purpose vehicle only holds a minority position in the underlying portfolio company. In that scenario, the special purpose vehicle will not be treated as an operating company for purposes of the VCOC exemption due to the fact that it is not primarily engaged, directly or through a majority owned subsidiary, in the production or sale of a product or service other than the investment of capital.
  • If a venture capital fund seeking to rely on the VCOC exemption makes an investment which does not qualify as an investment in an operating company prior to making its first investment in an operating company, then such fund can never qualify as a VCOC.

Takeaway

A management rights letter is a key aspect for venture capital funds when investing in companies, as it enables funds to raise capital without subjecting the activities of the fund to the various restrictions imposed under ERISA. Requests for management rights letters are fairly common in today’s market and do not impose significant burdens on the companies from whom such letters are sought.


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Completing A Name Change Without Shareholder Approval

Guest Post by Laura Anthony, Esq – Legal & Compliance, LLC

Generally a name change is completed through an amendment to a company’s articles of incorporation.  Moreover, amendments to articles of incorporation generally require shareholder consent, which can be time-consuming and expensive and become even more so if the company is subject to the reporting requirements of the Securities Exchange Act of 1934.

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‘Get Out of Jail Free’ Card

Joseph W. Bartlett, Co-Founder of VCExperts.com

Various attacks are mounted against the boards and managers of U.S. publicly held companies based on alleged deficiencies in the disclosure of financial results, the prosecution’s case buttressed by a emails discovered in the cloud from disgruntled insiders. The legal issues have been analyzed ad infinitum by the media and legal commentators. There is no effort from this corner to add to that enhanced commentary.

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Activists – The Problem for U.S. Leadership in Global Capital Markets

Joseph W. Bartlett, Council, Reitler Kailas & Rosenblatt LLC

A lively debate is cascading through the U.S. Capital Markets, triggered by the success of well-heeled investors in public markets labeled “activists.”

Bebchuk vs. Lipton

On the one hand, the applause in favor of activists is led by certain academics, the chief being Professor Lucien Bebchuk, who has reported.

“Empirical studies show that attacks on companies by activist hedge funds benefit, and do not have an adverse effect on, the targets over the five year period following the attack.

“Only anecdotal evidence and claimed real-world experience show that attacks on companies by activist hedge funds have an adverse effect on the targets and other companies that adjust management strategy to void attacks.

“Empirical studies are better than anecdotal evidence and real-world experience.

“Therefore, attacks by activist hedge funds should not be restrained but should be encouraged.”

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Court Confirms Takeover Target’s Right Not to Negotiate With Competing Bidder

Guest Authors: Abigail Pickering Bomba, Steven Epstein, Arthur Fleischer, Jr., Peter S. Golden, David B. Hennes, Philip Richter, Robert C. Schwenkel, John E. Sorkin, and Gail Weinstein – Fried, Frank, Harris, Shriver & Jacobson LLP

In In re Family Dollar Stores, Inc. Stockholder Litigation (Dec. 19), the Delaware Court of Chancery continued its trend of increased deference to decisions of independent directors, whether under the business judgment rule or the enhanced scrutiny standard of Revlon. The court concluded that Family Dollar Stores, Inc. (“Family”) did not breach itsRevlon duty to maximize stockholder value when it decided not to negotiate with a competing bidder to seek to improve the terms of the competing bid. The court refused to grant the plaintiffs’ request that the court enjoin the stockholder vote on the proposed merger of Family with Dollar Tree, Inc. (“Tree”) until Family had negotiated in good faith with the competing bidder, Dollar General, Inc. (“Dollar”).

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Delaware Court Finds Financial Advisor Liable for Aiding and Abetting Fiduciary Duty Breaches by Board of Directors

Guest post by Attorneys at  Davis Polk & Wardwell LLP

On March 7, 2014, Vice Chancellor Travis Laster of the Delaware Court of Chancery found a financial advisor liable for aiding and abetting breaches of fiduciary duties by the board of Rural/Metro Corporation in connection with the company’s 2011 sale to an affiliate of Warburg Pincus LLC. In its 91-page, post-trial opinion, the Court concluded that the financial advisor allowed its interests in pursuing buy-side financing roles in both the sales of Rural/Metro and Emergency Medical Services (“EMS”) to negatively affect the timing and structure of the company’s sales process, that the board was not aware of certain of these actual or potential conflicts of interest, and that the valuation analysis provided to the board was flawed in several respects. Both the Rural/Metro board of directors and a second financial advisor to Rural/Metro settled before trial for $6.6 million and $5.0 million, respectively.

This opinion is the latest example of the Court of Chancery’s focus on conflicts of interest involving sell-side financial advisors, as most recently demonstrated in the Del Monte and El Paso decisions. Rural Metro thus underscores the very real and potentially significant liabilities to financial advisors. It also serves as a salient reminder that the actions of advisors, including those carried out unbeknownst to the board, may be imputed to boards that fail to exercise reasonable oversight of their so-called informational “gatekeepers” in a sale process.

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