In the course of raising money, start-up companies are often asked by investors to sign a “Side Letter.” A Side Letter is a short agreement (perhaps 2 -3 pages) that typically asks for additional investor rights, such as information rights and pro-rata rights.
Although these short agreements are commonly requested and generally straightforward, there isn’t a standard template or form of Side Letter. And in some cases Side Letters include provisions that can be onerous if the company signing the Side Letter is not careful. Before you sign a Side Letter, here are some things you should be aware of.
- What are Side Letters?
A Side Letter is typically a short agreement between an investor (usually a fund or other institutional or professional investor) and the company the investor is investing in, that outlines additional specific terms and conditions not included in the primary financing documents (such as a convertible note, a Simple Agreement for Future Equity (“SAFE”), stock purchase agreement or other financing document).
Usually, it’s the investor that asks for a Side Letter, as the additional terms and conditions are typically favorable to the investor.
Side Letters are negotiated alongside the primary financing documents, and are executed with the primary financing documents (usually company’s execution of the Side Letter is an express condition of the investor signing the primary financing documents).
- Why is my investor asking for a Side Letter?
As noted above, investors ask for a Side Letter in order to include additional terms and conditions as part of a financing. There are a few reasons for this:
First, in many cases the primary financing documents that are being used for a financing may NOT include the additional terms and conditions that an investor is asking for. This is especially the case with the use of a SAFE or convertible note, as those documents are typically shorter and often don’t include provisions relating to investor rights.
Second, even where the primary financing documents might include investor rights (such as pursuant to an investor rights agreement that is included as part of a financing), the investor may want additional rights that are unique to that investor, or the company may not want to grant to all investors through the financing documents.
With Side Letters, a separate (or “side”) negotiation takes place between the company and the investor to agree on these additional requested terms.
- When is it appropriate to enter into a Side Letter?
Institutional or professional investors often ask for a Side Letter, whereas individual investors or smaller investors may be less likely to ask for a Side Letter.
Also, as noted above, financing rounds using fairly simple convertible notes or SAFEs often involve investor Side Letters, as the primary financing documents in those cases don’t typically include investor rights. Thus, it would not be unusual to enter into Side Letters for these types of financings.
Moreover, in a SAFE or convertible note financing where one or more investors is acting as a “lead” investor (i. they are putting in the most amount of money in a financing round, and/or are dictating the terms of the financing round, such as the total amount invested, the valuation, the type of financing instrument being used, etc.), it is common for the “lead” investor to ask for a Side Letter with additional rights. The “lead” investor is taking on greater work and responsibility in negotiating and reviewing the financing documents for a financing round (and potentially taking on greater risk as they are investing the most money and setting the terms). To balance that risk, it is not unusual for the “lead” investor to ask for additional rights.
Whether or not a company should agree to enter into a Side Letter for a particular investor will depend on a number of circumstances, including how onerous the terms and conditions are (some of which will be discussed below), the amount be raised from the investor, how important that investor is, and whether entering into a Side Letter may trigger a most favorable nation clause (MFN) that might require the company to grant similar rights to other investors with an MFN.
Ideally, though, from a company perspective, the company should limit the number of Side Letters.
- What provisions might I see in a Side Letter?
Side Letters are generally drafted and provided by an investor and can include any number of terms and conditions that the investor requires as a condition to their investment.
While these terms and conditions can be unique to the investor, in most cases, in the context an investment by a professional or venture capital investment firm into a private, early stage company, a Side Letter will typically include one or more of the following:
- information rights & reporting obligations
- pro-rata rights
- “Major Investor” rights
- management rights
- approval rights
- most favored nation (“MFN”) rights
Information rights typically require the company to provide periodic information to the investor, such as quarterly financials, annual financials, access to a cap table, and other periodic information regarding the operations of the company that the investor may request.
Pro-rata rights relate to the right of the investor to purchase a portion of any future security issuances of the company (which could be future issuances of shares, SAFEs or notes) based on the investor’s current ownership or investment in the company, and receive notices with respect to such future issuances.
“Major Investor” rights is a term used in financing documents that relate to either information rights or pro-rata rights, or both, and is a short hand way for investors to ask for information rights or pro-rata rights as may be defined in future primary financing documents.
Management rights relates to an investor’s right to be involved in management decisions of a company, and are typically asked for by investors who are subject to certain requirements to ensure compliance under ERISA (typically a very large investment fund that has pension, endowment or other investors as part of the fund that are subject to ERISA). These rights typically only relate to a financing round where actual shares are being issued.
Approval rights require the company to seek approval of the investor before taking particular actions as specified by such approval right. Such approval rights might relate to approving an annual budget, taking on debt of a certain amount, amending the company’s charter or other core corporate documents, changing or adding someone to the board, issuing more shares or SAFEs/notes, or other important actions.
Most Favored Nation or MFNs ensures that with respect to any terms or document subject to the MFN, the investor holding the MFN always benefits from terms at least as favorable as those that the company might grant to other investors.
Note that the above list is by no means exhaustive, and in many cases investors will ask for provisions specific to the investor or situation.
- Which rights are generally OK to give to Investors?
- information rights & reporting obligations
- management rights
It is common for investors to ask for Information rights and companies typically grant such rights. However, companies should be aware of who they grant such rights to, in order to understand/track what their information and reporting obligations are, and to whom. Companies may also want to consider confidentiality obligations, and the ability to restrict access to competitive or sensitive information.
Management rights typically only come up in a financing round where actual shares are being issued, and must be granted to allow an investment fund subject to ERISA requirements to invest in a company. As such these are typically granted by the company when asked.
- Which rights should I consider pushing back on in a Side Letter?
- pro-rata rights
- “Major Investor” rights
- approval rights
- most favored nation (“MFN”) rights
Pro-Rata rights. While investors commonly ask for pro-rata rights, companies need to be thoughtful of who they grant pro-rata rights to and how often they grant such rights. In many cases, early founders are “flattered” that investors would want to invest in future rounds. However, this right is not an obligation – it simply gives the investor the option, but not the obligation, to invest. Moreover, in order to allow the investor to exercise its pro-rata rights, notice is typically required to be provided to any investor holding a pro-rata right. Because pro-rata rights, including such notice rights, can be hard to manage (esp. if the number of investors holding such rights increases over time), it is typical for companies to limit such rights only to large or “Major” investors as may be defined in later financing documents. For this reason, companies should always be thoughtful before granting pro-rata rights via a Side Letter.
Major Investor rights. Similarly, companies should always be thoughtful before granting “Major Investor” rights to investors (which depending on the language may grant either information rights, or pro-rata rights, or both, to an investor, as may be granted to future investors who are defined as “Major Investors” in a future financing round). Ideally the company should limit “Major Investor” rights only to investors who specifically meet that definition as may be defined in a future financing.
Approval Rights. Any approval rights requested by an investor should always be carefully reviewed and scrutinized. While it is understandable that investors may want some level of transparency and control over a company it has invested in, such rights may result in a loss of the company’s ability to operate freely without seeking approval of investors – investors who may not be up to speed on the day to day realities of the company and its business. We’d strongly suggest seeking counsel before agreeing to such provisions.
MFNs. Likewise, the granting of Most Favored Nation or MFNs should be carefully scrutinized, both in terms of language and scope. In some cases, it may not be obvious that a Side Letter contains an MFN clause (the language doesn’t always use “MFN” or “Most Favored Nation” explicitly to grant such rights).
- How and when will I know whether an investor wants a Side Letter?
In some cases lead investors will negotiate a term sheet with the company, in which case the term sheet may call out specific rights the investor is asking for, which will be included in a Side Letter.
In other cases investors may request or provide a Side Letter during the drafting/financing process. Ideally an investor will not “spring” a Side Letter on a company late in a process, especially where the Side Letter includes more substantive provisions such as approval rights and pro-rata rights. However, it’s not uncommon, and typically seen as OK on the part of a company, if an investor provides a Side Letter late in the process so long as it only involves granting information rights or management rights.
At the point where a company has agreed (verbally) with an investor with respect to a financing, especially with respect to any early stage (seed or angel) investment involving SAFEs or convertible notes, and to the extent no term sheet has been provided or negotiated, the company may want to ask an investor whether the investor has as form of Side Letter it expects to execute as part of the financing, to prevent any issues down the road where the Side Letter contains any unexpected or undesirable terms.
- What are the drawbacks to entering into a Side Letter?
So long as the company is OK with granting the rights provided for in a Side Letter, then in and of itself it’s generally not a problem for a company to enter into a Side Letter with an Investor.
However, the issue with entering into a number of Side Letters can be accretive … it can be cumbersome to manage and track multiple Side Letters with the same or differing rights granted to various investors.
In particular, tracking and ensuring a company has not breached an MFN can be difficult, especially as time passes and the company forgets about which investors hold the MFN.
Likewise, tracking and ensuring the company has properly notified investors who hold pro-rata rights can slow down the process of deciding on the allocation with respect to a new financing round, especially since the company is typically trying to move fast and “strike while the iron is hot” in a financing.
- Should I bother having a Side Letter reviewed if I’m OK with the rights being granted?
While this may sound self-serving, we always recommend that a company have a Side Letter reviewed by counsel, even if relatively short and straightforward.
As noted, sometimes provisions such as an MFN are not drafted in such a way that it is obvious that the investor is asking for an MFN in certain circumstances.
In other cases, provisions such as pro-rata and information rights still need to be negotiated – the company may be OK with granting such rights, but will still want to think about the term/length that such provision will last, or the term of the Side Letter overall, the scope or definition of such rights, or the calculations used to determine the rights granted.
Given how important the rights are, and given the shortness of the typical Side Letter, there are typically not a lot of hours involved in reviewing and negotiating Side Letters, but the impact of a poorly drafted or negotiated Side Letter can be significant.
- Is there a standard form of Side Letter?
Unlike SAFEs, there is not necessarily a standard form of Side Letter that most investors use. As noted, in many cases Side Letters are created by investors to address particular rights or issues that are important to an investor or investment fund.
However, two common forms of Side Letter are available that many investors or companies use. The first is a form of pro-rata Side Letter offered by YC and found at:
YC Safe Financing Documents | Y Combinator
The second is a form of Management Rights Letter offered by the National Venture Capital Association (NVCA) as part of their standard set of priced round preferred financing documents, and can be found at:
Model Legal Documents – National Venture Capital Association – NVCA
Neither is exhaustive or reflective of all the terms and conditions that are often encountered in a Side Letter, but provide commonly seen language regarding management rights and pro-rata rights.
Inceptiv
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