Part four in a series of seven articles overviewing founders’ rights on a term sheet.
You’ve signed a term sheet with your lead investor! Now, the deal teams begin to draft and negotiate the deal documents among you (as the company’s management), the company’s legal counsel, the lead investor and the investor’s legal counsel. You may notice that one of the deal terms in the term sheet stipulates that the company will grant the investor with customary information and inspection rights and board observer rights.
3 Things You’ll Learn About Information, Inspection and Observer Rights
- Standard information, inspection and observer rights from an early stage through a later-stage venture financing
- What’s entailed in negotiating information, inspection and observer rights in an NVCA-style Investors’ Rights Agreement at various stages of the company’s business
- Time frames for various aspects of information rights, inspection rights and observer rights
In any venture financing, from Series Seed and beyond, the company will negotiate with its new preferred stockholders for two main types of investor rights: control rights and economic rights. In my last article, I summarized the registration rights afforded to investors (and sometimes founders) under one of the standard financing documents, the Investors’ Rights Agreement. This article focuses on the information, inspection and observer rights under the Investors’ Rights Agreement that are generally negotiated in a NVCA-style venture capital financing.
The Investors’ Rights Agreement (IRA) is one of the densest transaction documents in an equity financing and covers multiple subjects, which may feel intimidating for founders as they review the various transaction documents, including the Certificate of Incorporation, Stock Purchase Agreement, Right of First Refusal Agreement, Voting Agreement and Investors’ Rights Agreement.
As its title suggests, the IRA includes various contractual rights that the company provides to its investors after the closing, commonly including registration rights, information rights, inspection rights, observer rights, rights of first offer (also known as participation rights) and post-closing covenants. After the transaction closing, this agreement becomes a staple resource for the founding team, board of directors and company counsel to review and ensure the company complies with its investor rights.
This article provides a helpful resource for founders to reference as they prepare for the equity financing and negotiate the information rights with help of the company counsel.
First, it is important to understand that Delaware law provides stockholders of a Delaware corporation with certain statutory information and inspection rights. In short, the stockholders have the ability to obtain, review, and make copies of the company’s books and records and stock ledger with some limitations and subject to whether the stockholder(s) have waived these statutory rights.
In the IRA, the investors of the company are often provided with contractual information rights where the company agrees to provide the investor’s with regular access to the company’s financial and capitalization table information. The common information rights include:
Annual financial statements. The annual financial statements are required to be delivered to the investor within 90 to 120 days of the end of each applicable fiscal year. The financial statements include the balance sheet, statements and income and cash flows, and a statement of stockholders’ equity as of the end of the fiscal year. Generally, the annual financial statements must be compliant with Generally Acceptable Accounting Principles (GAAP) subject to normal year-end audit adjustments (if applicable) and not required to contain all notes that may be required by GAAP.
Quarterly financial statements. The quarterly financial statements for the first three quarters of the company’s fiscal year are required to be delivered to the investor within 45 days of the end of each applicable quarter. The financial statements include the unaudited balance sheet, unaudited statements of income and cash flows, and a statement of stockholders’ equity as of the end of the applicable quarter. Generally, the quarterly financial statements must be GAAP compliant.
Quarterly capitalization table. The quarterly capitalization table of the company to be delivered within 45 days of the end of the applicable quarter. The capitalization table must at the minimum provide each investor with the ability to calculate their respective equity ownership percentage of the company as of the end of the applicable quarter.
Monthly income statements. An unaudited income statement and balance sheet of the company must be delivered to the investor within 30 days of the end of the applicable month.
Annual budget. Within 30 days prior to the start of the next fiscal year, the company must provide the investors with a board approved budget and business plan for the next fiscal year. Typically, the investors will require that the budget and business plan is prepared on a monthly basis, including balance sheets, income statements and statements of cash flow for each month.
Catch-all requested information. Some investors may require that the company provide them with additional information relating to the financial condition, business, prospects or corporate affairs as reasonably requested by the investor. The company is not required to share information that falls under these catch-all information rights to the extent such information is protected by trade secret and/or if sharing the information would adversely impact the company’s attorney-client privilege with the company’s counsel.
In addition to the above list, some investors may negotiate that the company update the investors on material litigation, regulatory matters, 409A reports, material defaults under credit and loan facilities and other material events and occurrences to the business. If the investor is entitled to designate a board seat on the board of directors, providing such additional information rights creates an administrative burden on the company to duplicate its reporting efforts at the board and stockholder level.
Information Rights: Early-Stage Considerations
Typically for the Series Seed to Series A round, the financial statements are unaudited given that the cost of obtaining audited financials is not the best use of the company’s limited funds at the earlier stage.
Additionally, it is common to leave out the monthly income statement requirement for an early stage company to lessen the administrative burden on the company and its small team to produce monthly reports.
Finally, if the company is on Carta or a similar capitalization table management platform, the investors will often waive the quarterly capitalization table requirement so long as the investor has access to the platform to find the desired information.
Information Rights: Later-Stage Considerations
At later stages of the company — Series B and onward — it is common for the lead investor to require that the financial statements are certified by an officer of the company, for instance the CFO. The certification statement will certify that the statements were consistent with GAAP and fairly present the financial condition of the company.
Additionally, as the company progresses through financing rounds, the lead investor will likely require that the company’s annual financial statements are audited and certified by independent public accountants of a nationally recognized firm. Typically, this audit requirement is not put in place until the Series B round but sometimes may be required earlier, particularly when the company is operating in a highly regulated industry.
If the company does not quite feel ready to take on the audited financial requirement, the company and lead investor may agree that audited financials will start at the earlier of a set date in the future (e.g. the next applicable fiscal year) or once the company obtains audited financials. This delayed start provides the company with a buffer before it is required to comply with an audited financial reporting requirement.
Information Rights: Limitations
The information rights are typically limited to investors that achieve the major investor status on the company’s capitalization table, which is reserved for investors who purchase up to a certain amount of shares and increase as the company raises additional capital.
For example, it is common for a major investor threshold to be set between $1 million and $2 million at the Series Seed round but will proportionally increase as the company raises later stage funding. 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, typically the company is not required to provide investors that are competitors of the company with information rights. This concept is especially important when the investor is a corporate strategic investor (versus a traditional venture capital investor) and may have conflicts of interest with learning such information that could be used to further the corporate strategic’s business ventures. The lead investor usually negotiates a carve out to the competitor status to ensure that they are never treated as a competitor regardless of whether they meet the definition.
Inspection rights under the Investors’ Rights Agreement put in place a contractual obligation of the company, which may be exercised by the investor at any time while the agreement is effective. The inspection rights typically allow each major investor who is not a competitor 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.
The inspection rights are limited to the company’s normal business hours and must be reasonably requested in advance by the investor exercising the inspection rights. The company is not required to provide any trade secrets or confidential information (unless covered by a NDA) or any information that would adversely affect the attorney-client privilege between the company and its legal counsel. Inspection rights are fairly standard and rarely negotiated between the company and the lead investor.
Observer rights may be provided to the lead investor and key investors.
An observer right affords the investor with the ability to appoint a representative to attend all meetings of the board of directors in a nonvoting observer capacity and to receive copies of all board materials (e.g. notices, minutes, consents and other materials) that the company provides to its directors.
The representative is bound by confidentiality with respect to all information that the representative learns in their observer role by way of attending meetings and receiving board related documentation.
The observer rights are typically limited by an ownership threshold, which requires that the investor hold at least 25 percent to 50 percent of the shares it purchased at the time of the financing round in order to maintain the observer rights. This prevents the investor from transferring its shares and maintaining an important control right in the company.
Some companies prefer to move any observer rights to a side letter agreement between the company and the investor instead of including these rights in the Investors’ Rights Agreement.
Additionally, the observer rights are not applicable if the investor has a director that is designated on the board of directors. This typically means that the lead investor will maintain an observer right in the next financing if they no longer hold a board seat right at that point in time.
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 the company’s trade secrets, and to guard against any conflict of interest if the representative is a competitor of the company.
If the investor is a foreign investor in a U.S.-based company, observer rights may trigger Committee on Foreign Investment in the United States (CFIUS) regulations issues because such rights cut against the requirement that foreign investors hold a passive investment. Careful attention should be given to any foreign investment to ensure compliance with CFIUS in all respects.
Finally, some companies prefer to move any observer rights to a side letter agreement between the company and the investor instead of including these rights in the Investors’ Rights Agreement. The purpose of shifting these rights to a side letter may help limit negotiations with other investors who feel they are also entitled to observer rights. The company should discuss the approach with its legal counsel to determine whether it is appropriate for the company to include observer rights in the Investors’ Rights Agreement or under a separate agreement.
When Do These Rights Terminate?
The information, inspection and observer rights summarized above generally terminate and expire upon the earliest to occur: immediately prior to the company’s initial public offering; when the company first becomes subject to periodic reporting requirements with the SEC; or upon the closing of a Deemed Liquidation Event.
- Initial public offering: The rights will terminate immediately prior to the company’s first underwritten public offering of its common stock under the Securities Act of 1933, as amended.
- Reporting company: A company will be required to publish periodic reports with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended, upon its public offering but it may also become subject to these laws earlier if it has more than $10 million in total assets and a class of equity securities, like common stock, that is held of record by either 2,000 or more persons 500 or more persons who are not accredited investors; or it lists the securities on a U.S. exchange.
- Deemed liquidation event: Generally speaking, the deemed liquidation event includes the sale of the company by way of merger or consolidation in which the company sells at least a majority of its capital stock, or a sale or exclusive license deal of substantially all of the company’s assets.
Although the NVCA template of the Investors’ Rights Agreement creates a shared language between investors and companies and their respective legal counsels to negotiate information rights, these rights are often customized to match the company’s stage and ability to comply with the ongoing reporting obligations.