What are Board Observer Rights, and How Should They be Structured?

Angel investors and venture capitalists often look for ways they can monitor their investments and gain pertinent information on startups in which they invest. One way that investors and investment firms can access this information is by being granted board observer rights. Among other interests, these confer the rights of investors to sit in on meetings of the startup’s Board of Directors.

Board observer rights often give observers the right to be present and participate during Board meetings and report back on relevant happenings to other members of their investment firm; observers are not afforded voting rights. Likewise, the observer does not have the fiduciary duties that members of the board have.  However, many startups, recognizing the potential value of observers from experienced venture capital firms and angel investor groups, allow limited rights for observers to participate in discussions.

Key Provisions of Board Observer Rights Letters

When a private company is in its startup stages, its staff (management especially) are often limited in manpower and expertise and could benefit from the opinions of experts.  And, in connection with raising money, the founders of the start up may not yet be ready to give an investor “control” through board votes.  However, they do value the expertise of certain investors and would appreciate their participation in strategic discussions and planning.   To ensure companies are protected, a contract referred to as the “Board Observer Rights Letter” is drafted. A robust and properly structured letter often covers the following areas:

The obligations investors must exercise to receive board observer rights. For instance, how many shares of stock must maintain in order to keep those rights?

The founders may find it necessary to exclude an investor from portions of meetings, particularly where the observer may have a conflict of interest.  For instance, it may be appropriate to exclude an observer from certain discussions related to trade secrets or when litigation is possible and attorney-client privilege must be maintained. Other times, an investor might acquire a financial stake in a competitor and a conflict of interest arises.

The letter should address how long the observer rights remain in place.   Once a company is out of its startup stages, observer rights often become unnecessary or burdensome. In the letter, companies can specify that these rights end when, for example, there is an IPO, upon the closing of the next round of funding, if the investor no longer holds a minimum number of shares of preferred stock, or a specified future date.

Information Rights

Tangentially related to board observer rights are information rights. These two types of rights enjoyed by investors are similar in many ways; for one, information rights are often contingent on investors’ holding a certain amount of stocks. Additionally, information rights give investors physical copies of certain financial materials – such as quarterly financial statements and annual budgets – within a specified period of time. Other benefits conferred to investors with information rights include inspection rights and access to certain members of management.

Conclusion

There is little common law guidance on the rights of board observers, which makes it imperative to draft an effective letter that protects the rights of you and your company. Doida Law Group is well-equipped to help you draft a board observer rights letter so your startup is best-positioned to receive benefits while maintaining adequate control – now and in the future.

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