When investing in startups venture capital funds often request what is known as a management rights letter. This letter typically gives investors additional rights and increased access to the company’s financial information and corporate decision-making. This is desired by venture capital funds because it may exempt them from certain federal regulations.
The Employee Retirement Income Security Act of 1974, or ERISA, imposes strict restrictions on the investment of pension plan assets. It’s not uncommon for pension plans to invest in venture capital funds and when that happens, the assets of the fund can become subject to ERISA and its requirements. There are, however, a couple of exemptions.
Under the first exemption, funds can be exempt if they limit ERISA benefit plans to holding less than 25% of the value of any class of equity interest in the fund. But the 25% limit is too restrictive, so funds typically rely on the second exemption, known as the VCOC exemption.
This refers to an exemption that applies to funds that qualify as “venture capital operating company.” In order to be a VCOC, there are two requirements that must be met. The first is that at least 50% of the fund’s assets are invested in operating companies or in certain derivative investments. An operating company is a company whose main business involving making or selling a good or service. A derivative investment is a venture capital investment where the fund no longer has management rights over the company (such as after an IPO) and only qualifies as a VCOC for a limited period of time.
The second requirement is that the fund, in the ordinary course of business, exercises management rights with respect to at least one operating company. These are rights which allow the fund “to substantially participate in, or substantially influence the conduct of, the management of the operating company.”
Management Rights Letters
Management rights letters are intended to create contractual management rights so the venture capital fund can take advantage of the VCOC exemption from ERISA plan asset rules. It may, for example, allow the investors to attend board meetings or receive periodic copies of the company’s financial statements.
For venture funds, being exempt from ERISA regulations can have major benefits. Without an exemption, the fund’s assets may be required to be held in trust and its managers could be prevented from making certain investments.