Preferred Stock Financings: Information Rights

When you buy stock of a publicly-traded company, there's lots of information available about the company's business and finances.  This is because publicly-traded companies are required by law to publish their financials and other company information.  

The world is very different when investing in private companies.  Absent an agreement, private companies have very few requirements to provide investors with information on the company’s business and finances.  That’s where information rights come in.
 
This post explores information rights typically obtained by preferred stockholders in private companies.

​The basic information rights provided to preferred stock investors are:

• Financial Statements.
• Capitalization table.
• Budget.
• Inspection rights.

 
Financial Statements

• Annual Audited Financial Statements.  Typically, companies provide investors with audited financial statements (balance sheet, income statement, statement of cash flows, and a statement of securityholders’ equity).  These audited financial statements are typically provided to investors within 60-90 days after the end of the company’s fiscal year, and there’s generally a requirement that the audited financials be prepared by a nationally recognized accounting firm (such as one of the “big 4” accounting firms).  Why are audits required?  Financial statements that have been audited have withstood a rigorous review by the accounting firm, so investors can take comfort that the financials are accurate (note that if the company is committing fraud, such as was the famous case with Enron, the accounting firm may not catch the fraud and so the audited financials may be inaccurate).  The requirement for a national accounting firm is to prevent a Bernie Madoff situation (Madoff used a small, relatively unknown accounting firm).
  • Management Letter.  When an accounting firm conducts an audit, the audited financial statements are usually accompanied by a “management letter” which identifies weaknesses in the company’s internal financial controls.  Some investors will negotiate to receive a copy of the annual management letter in addition to the annual audited financial statements.
  • Certification.  Investors often require that the Chief Executive Officer and Chief Financial Officer certify the accuracy of the audited financial statements.  The reason for this is that if the CEO and CFO certify the financial statements while knowing they are not accurate, the investors could sue the CEO and CFO personally for fraud.
• Quarterly Unaudited Financial Statements.  Investors typically also receive quarterly unaudited financial statements from the company for the first 3 quarters of the company’s fiscal year.  The audited financial statements are in lieu of the fourth quarter unaudited financial statements.  These unaudited statements should take the form of the audited statements, and should follow generally accepted accounting principles (GAAP), but may not have all of the footnotes found in the annual audited financial statements.  These statements are prepared by the company (with no review by the auditor) and are usually sent to the investors within 45 days after the end of the fiscal quarter.
• Monthly Unaudited Financial Statements.  Sometimes investors will negotiate for monthly unaudited financial statements in addition to the quarterly and annual financial statement requirements.  This provides the investor with the most recent changes of financial position, and enables the investor to monitor more carefully the progress and financial health of the company.  Similar to the quarterly unaudited, these are prepared by the company in accordance with GAAP but may not have the GAAP footnotes found in audited financials.
• Subsidiaries.  If the company has subsidiaries (most early-stage companies do not, but later-stage companies often do), then the financials will be consolidated to include the finances of all subsidiaries.  In some cases where there are one or more significant subsidiaries, I have had investors ask for the separate financial statements for these subsidiaries in addition to the consolidated financial statements.  This way the investor can have a clear picture of the financial status of each major subsidiary as well as for the company overall.

 
Budget
In addition to the financial statements, preferred stock investors also typically negotiate for the company to prepare and deliver to the investors an annual budget which will contain monthly forecasted revenues, expenses and cash position.  This budget is useful to track the company’s performance against its projections.
 
Capitalization Table
Investors will also typically negotiate to receive an updated capitalization table from the company on a quarterly basis.  This is important as the cap table allows the investor to monitor the dilution the investor experiences because of additional stock issuances and issuances of stock options.
 
Inspection Rights
Investors also negotiate for what are known as “inspection rights”.  These rights enable the investor to obtain access to the company’s offices and locations, company records, and access to the company’s officers to discuss the business, finances and prospects of the company.  These inspection rights are often limited so that the company doesn’t have to provide access to an investor if the Company believes that the investor is a competitor, or that the information to be disclosed is a trade secret or confidential information (unless the investor has signed a strict confidentiality agreement), or the disclosure would create a conflict of interest with the investor, or the disclosure would violate the attorney-client privilege between the company and its attorneys (such as information relating to pending or threatened litigation).
 
 
Limitations

• Major investors.  Companies will often limit the information rights discussed above to large investors, called “Major Investors.”  What is a major investor is often the subject of pointed negotiation, as the burden and risks to the company of disclosing sensitive information about the company are substantial, and so the company wants to limit the distribution of this information as much as possible.  If an investor is not a “Major Investor” it may be possible to negotiate a side letter to obtain some of the rights discussed above.
• Competitors.  Companies will typically want to not provide sensitive information to a corporate investor who has competing businesses, or to an investor who has other investments in the company’s competitors.  Venture capitalists often have many investments in similar or tangential sectors, and so this can be a problem for some venture capitalists.  Often, venture capitalists will negotiate a specific provision addressing this issue.

 
Termination of Rights
The information rights typically terminate immediately before the company’s initial public offering, the sale or merger of the company, or if an investor loses Major Investor status.
 
 
© Allen J. Latta. All rights reserved.