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Venture capital firms: getting the right rights

A recent Department of Labor advisory opinion has at last clarified the ways in which venture capital firms can avoid ERISA's strict fiduciary mandates. Legal firm Palmer & Dodge explains.

Venture capital firms will have more comfort that they can avoid ERISA's strict fiduciary mandates under a recent Department of Labor (DOL) advisory opinion. The opinion clarifies for the first time what ‘management rights' satisfy the ‘venture capital operating company' (VCOC) exception of the ERISA ‘plan asset' regulations.

As background, a fund can generally avoid being subject to ERISA requirements by limiting benefit plan investors to less than a 25 per cent interest in the fund. If a fund does not wish to shut out that major source of capital, it can also avoid ERISA by satisfying the VCOC exception.

Under the VCOC exception, a fund must obtain management rights from portfolio companies representing a certain portion of its assets (although, as a matter of administrative convenience, a fund may choose to obtain ‘management rights' from each of its portfolio companies).

‘Management rights' are contractual rights directly between a fund and a portfolio company to participate substantially in, or to influence substantially the conduct of, the management of the portfolio company. The specific rights that must be obtained are determined under the facts and circumstances of each case, and the DOL had given no clear guidance before. For example, the DOL had previously stated that the right to appoint a director would constitute ‘management rights' but had not said whether that was a necessary right, nor had it directly addressed other rights.

Significantly, the recent advisory opinion creates a safe harbour set of rights where a board seat is not obtainable, including:

• Delivery of quarter-end and year-end consolidated balance sheets and statements of income and cash flow information, and copies of reports filed by law or pursuant to the terms of any outstanding indebtedness;

• Provision of copies of all documents, reports, financial data, and other information (including subsidiary information) as the fund may reasonably request;

• Permission of any authorised representative of the fund to visit and inspect any of the properties of the company and its subsidiaries, including their books, and to discuss the company's and subsidiaries' ‘affairs, finances, and accounts' with their officers, at such times as the fund may reasonably request; and

• The right to ‘consult with and advise' the management of the company and its subsidiaries, upon reasonable notice at reasonable times from time to time, on all matters relating to the operation of the company and its subsidiaries.

The advisory opinion is extremely useful in this regard and substantiates the approach to ‘management rights' agreements.

Interestingly, the DOL's opinion is based on the investor's representation that the above set of rights is greater than the rights normally obtained by institutional investors in portfolio companies. It is not clear how important that was to the opinion. As many institutional investors become more proactive in the management of the companies in which they invest, the set of rights described above may not continue to be greater than those typically sought by and obtained by institutional investors. We will continue to monitor the DOL's pronouncements and trends of institutional investors as they may affect a VCOC's ‘management rights.'

Copyright © 2002 Palmer & Dodge LLP

Palmer & Dodge LLP represents private equity investors in fund formation and investment activities, including equity and debt financings, public offerings, M&A, management buy-outs, and corporate spin-offs.  We also represent large corporate clients in structuring and negotiating investments in venture funds.  Our significant experience providing securities, M&A and intellectual property counsel to life sciences and information technology companies enhances the value of our legal and strategic business advice to private equity clients.  For more information please visit www.palmerdodge.com