Ask A Mofo: Common Provisions in Venture Capital Term Sheets: Information and Observer Rights

The following article is part of our "Ask a MoFo" series, where we address some of the frequently asked questions our MoFo startup team is asked during the course of business. These questions span the entirety of the startup lifecycle – from questions relating to incorporation, to tips for a successful exit. We encourage you to submit questions you would like to see answered as part of this series to ECVCevents@mofo.com.

This article is one in a series of articles explaining various terms commonly seen in venture capital equity financings, keyed to the commonly referenced National Venture Capital Association (NVCA) documents.

What Are Information Rights?

In a typical venture-backed equity financing, it is common for at least some investors to negotiate for contractual rights to receive access to certain company information consisting primarily of financial and capitalization table information and sometimes including a formal board observer right. These rights are designed to provide investors with information about the company’s financial performance and operations so they can assess the progress of their investment and provide guidance to the company when necessary.

What Types of Information Do Investors Receive Access to?

Information rights are negotiated and described in detail in the NVCA’s model of an Investors’ Rights Agreement. These rights will vary across deals, but they commonly include some or all of the following:

1. Annual financial statements. Investors often negotiate for the right to receive annual financial statements (i.e., balance sheet, statements and income and cash flows, and a statement of stockholders’ equity) as of the end of the fiscal year. These financial statements are typically delivered to investors within 90-180 days after the end of the company’s fiscal year. Investors may negotiate to receive audited financial statements, certified by independent public accountants of a nationally recognized firm. However, providing audited financials can be expensive for early stage companies, especially during the first few months of the year when public companies are demanding much of the attention of the accounting firms, and so it is not unusual for early stage companies to provide unaudited financials until later rounds of financing. Investors can also require that the financial statements must be certified by an officer of the company. The certification statement will show that the financial statements were prepared in a way that is consistent with generally accepted accounting principles (GAAP) and fairly present the company’s financial condition.

2. Quarterly financial statements. Investors will also often negotiate for the right to receive unaudited quarterly financial statements for the first three quarters of the company’s fiscal year. These statements are typically delivered to investors within 45 days after the end of the fiscal quarter.

3. Quarterly capitalization table. Investors may also negotiate to receive an updated capitalization table from the company on a quarterly basis. The capitalization table will typically provide each investor with the ability to calculate their respective ownership percentage of the company as of the end of that quarter.

4. Monthly income statements. Sometimes, investors will negotiate for the right to receive monthly income statements and balance sheets. For early stage companies, it is common to leave out this requirement to lessen the administrative burden on the company and its small team.

5. Annual budget. Investors may also require the delivery of a board-approved budget and business plan prior to the start of each fiscal year. Typically, the investors will require the budget and business plan to be prepared on a monthly basis which is useful to track the company’s performance against its projections. In many instances, a lead investor will require that the company prepare an annual budget, which must be approved by the board of directors, including the approval of the investor’s designee on the board.

6. Catch-all for requested information. Some investors may require that the company send them information related to the financial condition, business, prospects, or corporate affairs as requested by the investor.

Limitations

Typically, only Major Investors will be granted information rights. “Major Investors” are investors who purchase or own significant amounts of capital which are recorded on the company’s capitalization table. The share ownership threshold for Major Investors is defined in the NVCA’s Investors’ Rights Agreement. This limitation helps decrease the company’s overall reporting obligations so that it is required to share detailed information with only a handful of investors instead of all of the preferred stockholders.

Additionally, the company will not be required to grant information rights to investors who are competitors of the company. This limitation is important, especially when the investor is a strategic investor who has a competing business venture or who has investments in the company’s competitors.

Inspection Rights

Investors may also negotiate for “inspection rights” which allow Major Investors who are not competitors of the company to visit and inspect the company’s properties, examine its books of accounts and records, and discuss the company’s affairs, finances, and accounts with its officers.

Observer Rights

Occasionally, a large investor will negotiate for board observer rights, which will entitle the observer to (a) receive copies of all board materials (e.g., notices, minutes, consents, and other materials) that the company provides to its directors, and (b) be invited to attend all meetings of the board of directors in a nonvoting observer capacity. The board observer must keep all information learned in their observer role confidential. Observer rights are typically only granted to certain key investors who are not represented on the company’s board of directors.

Since these board observers are not full-fledged board members, they have no board level fiduciary duties to the company, and so the company has the right to withhold any information and exclude the representative observer from any meeting (or portion of a meeting) to protect the company’s attorney-client privilege with its counsel and to prevent disclosure of trade secrets.

Conclusion

Granting information rights demonstrates a company’s transparency and commitment to building a strong relationship with its investors. In granting these important rights, however, the company should ensure that the scope of these rights is reasonable and does not overly burden the company’s operations or compromise its competitive advantage. Experienced legal counsel can assist in identifying market standards according to a company’s stage of development, limit any unnecessary costs in complying with these obligations, and ensure that appropriate confidentiality protections are in place.