Information Rights

This post is by Jeff Carter from Points and Figures

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Information rights can be a very touchy thing in startup investing.  There are a lot of issues with them.  The biggest is that when a company releases information to investors, they’d like it to remain confidential.  That doesn’t always happen but if you are a good investor you keep it to yourself.

Here is what Brad Feld wrote in 2005 on Information Rights:

First up is Information Rights – the typical clause follows:

Information Rights: So long as an Investor continues to hold shares of Series A Preferred or Common Stock issued upon conversion of the Series A Preferred, the Company shall deliver to the Investor the Company’s annual budget, as well as audited annual and unaudited quarterly financial statements. Furthermore, as soon as reasonably possible, the Company shall furnish a report to each Investor comparing each annual budget to such financial statements. Each Investor shall also be entitled standard inspection and visitation rights. These provisions shall terminate upon a Qualified IPO.”

Information rights are generally something companies are stuck with in order to get investment capital. The only variation one sees is putting a threshold on the number of shares held (some finite number vs. “any”) for investors to continue to enjoy these rights.

The other is from the investor perspective.  You have committed risk capital and entrusted someone with your hard earned money.  You deserve to know how it is being used and also what your position on the capitalization table is.  But, you are probably not a “major investor” under the terms of a priced round term sheet.  Convertible debt notes don’t really talk about information.

Let’s say you angel invested in company A.  Company A goes along making their widgets.  They did a convertible debt note with a $8MM cap, a $1MM raise, 20% discount, and an 8% interest rate.  They continued to raise after you invested until they exhausted what was available under the terms of the note.

Where do you sit on that cap table?

Until the note converts, you don’t actually know.  You can only guess.  There are various ways of converting notes as well.  It’s not 2+2=4.  You need to know how the note will convert into the next round.

Suppose the next round goes off at $8MM to make this blogpost simple.  It happens in 12 months.  That means you get 12 months of interest at 8% added to your investment.  Remember, that also means that the entrepreneur is giving away a lot more equity than they thought they would.

Your note would convert into this round at $6.4MM.  If you invested $50k, you would own roughly .0075% of the company before the new money comes in.  If the new money comes in at a $7M pre, and $8MM post with a 10% option pool, you will own a bit less.

Should you get information rights?

As a VC, we try to keep information as tight as we can to the principles of the company and the board.  In term sheets, we do set minimum thresholds of shares to keep information close.  Often we will run into entrepreneurs that have raised money from as many as 30-40 people.  There is no way to keep information private if you let everyone have it.

If I put my angel investor hat on, I’d certainly like to know where I stand on the cap table.  I don’t need to  know the detailed strategic direction of the firm.  I do like to see headline numbers; sales, costs etc.  in broad brush strokes.  However, the most meaningful for me is to know my position because if the company exits, I’d like to know where I am in the waterfall.  But, to tell you the truth almost 99% of the time, a company looks like a black box to an angel.  You are investing with a blindfold on.

As a VC I am pretty cognizant of the travails of smaller investors.  We actively talk about how to distribute information to them in board meetings.  On some companies, we have conference calls where investors can call in and interact with the management team. On some, we distribute an email blast of the highlights.  But, we make sure the lines of communication are at least open even if we aren’t communicating the intricate details of every part of the business.  We also try and include some sort of ask that investors can act on to help the company move forward.

Coming from the trading pit, I am a pretty strong believer in transparency.  It doesn’t mean you share everything but it does mean you have respect for your other investors in the deal and you show them that respect and trust by sharing information that is important to them.

If you get the meddling investor, it’s up to the VC or the Angel deal lead to ward them off and shield the entrepreneur.  We have a conversation with CEO’s of companies about this prior to us investing.  We explain our role in doing this, why we are doing it and how it benefits them.  The important thing with meddling investors is to really communicate efficiently with the CEO to make sure you are doing what is right by them and the company.

As companies mature, they sometimes will do an inside round of financing. I had a few companies do that over the last year.  Often there will be preferences to those inside rounds.  They might be a liquidation preference, which dilutes the rest of the cap table, or a dividend preference, which is a different form of dilution.  Both are downside protective measures.

I had a company I angel invested in that did an inside round last year.  I didn’t even know they were doing the inside round.  I don’t know the terms of the round.  I don’t know anything about it.  I found out about it in an update.  It is highly doubtful that I would have invested even if given the opportunity, but it would be nice to know how the round affected my position on the capitalization table.

At our fund, we use Carta to manage our cap tables and we are pretty happy with it.  If our LPs want to know anything, we can share it with them easily and have a conversation about it.  I find that in the broader investing community, basic information like your percentage ownership in the company is not available to smaller investors.  They are usually the ones that were “valuable” in the beginning but they are soon forgotten later on.  Jason Calcanis has tweeted a lot about that over the past year.

I think that transparency ought to be a conversation early stage investors engage in this year.  There are reasons for it and certainly reasons not to be transparent.  But, when you aren’t it breeds a relationship of mistrust which leads to other complications.