Side Letter

What Is a Side Letter in Private Equity Deals?

A side letter refers to an agreement that startup founders and investors create to supplement the terms of co-investment rights in the financing documents. Unlike the shareholder's agreement or investment agreement that applies to all shareholders, a side letter is usually binding for the parties who sign it.

Side letters negotiate provisions that impact certain investors or founders. For instance, a side letter arrangement might provide one investor with information rights, board seats, or liquidation preferences that do not apply to other shareholders.

The intention behind having a side letter is to allow the involved parties to clarify or qualify terms from the financing agreements. These letters do not modify the core deal documents or address particular issues between those who sign them. This approach avoids making changes that would negatively affect all shareholders.

Side letters can cover various provisions, including voting rights, drag-along terms, future funding obligations, ROFR, and specific performance requirements. Anything affecting the rights or responsibilities of particular shareholders is fair game for a side letter.

Unlike oral agreements, a properly executed side letter is legally binding between the signing parties under contract law. However, side letters do not dilute or undermine the validity of the main financing agreements. They simply allow customized arrangements between certain shareholders beyond the scope of the core deal terms.

When Are Side Letters Used in Funding Rounds?

Side letters are typically requested during large, late-stage private equity or venture capital funding rounds, such as Series B, C, or later. They are less common in early-stage or seed funding rounds.

There are several key reasons why investors, fund sponsors, managers, or startup founders may request a side letter agreement:

• To negotiate terms that diverge from the standard financing documents. For example, a large investor may request additional favorable terms like extra board seats, voting rights provisions, or enhanced liquidation preferences not offered to other investors.
• Clarify ambiguous provisions in the main financing documents. If certain terms are unclear, a side letter can spell out the specific interpretation.
• Document verbal agreements or commitments made during funding negotiations. For instance, an investor may want a side letter to solidify promises about participation in future funding rounds.
• To provide specific requirements or provisions related to a particular strategic investor. For instance, a corporate venture capital firm may require side letter terms related to commercial collaborations, mergers and acquisitions, or future acquisition rights.
• To resolve contentious issues without revising heavily negotiated core documents. Side letters allow customization for certain investors while keeping standard docs intact.
• To disclose agreements that may present conflicts of interest if included in core documents. By separating these terms into a side letter, issues can be isolated.
• To gain a competitive edge when bidding for hot startup deals. Investors may offer preferential side letter terms to win the deal.

In summary, side letters tend to occur when deals are larger and more complex. They allow customization and help resolve issues outside the core documents.

What Terms Do Side Letters Commonly Address?

Side letters can be used to negotiate or clarify various provisions found in the main financing documents. Some of the most common terms addressed in side letters include:

Liquidation Preferences

Liquidation preferences outline how each investor will receive compensation if the company gets sold or goes bankrupt. Side letters may be used to adjust the liquidation preferences outlined in the financing documents granting investors preferential treatment. For example, through a side letter one individual investor could be given twice (2x) the liquidation preference while others receive once (1x).

Board Seats

Side letters can define board appointment rights not fully detailed in the main financing contracts. An investor may negotiate additional board seats or observer rights through a side letter agreement, which gives the investor more control and insight into the company or fund's operations.

Drag-Along Rights

Drag-along rights enable an investor to compel shareholders into accepting their desired exit strategy, such as an acquisition. A potential option to consider is using a side agreement that grants drag-along rights to a venture capital firm involved in the investment. This would outline the conditions for the investor to exercise their drag-along right.

Future Funding Commitments

Existing startup investors may desire the ability to participate in future funding rounds to prevent dilution. A supplementary agreement could establish the terms and conditions concerning an individual investor's rights for financing opportunities to address this. Alternatively, it could outline an individual investor's commitment to participate in rounds based on predefined milestones being achieved.

Key Benefits of Side Letters for Founders

Side letters can benefit startup founders and management teams during private equity negotiations. Here are some of the key advantages founders can gain from requesting or agreeing to a side letter:

- Negotiate preferential terms - Founders can use a side letter to negotiate terms that provide specific benefits or preferences for management and common shareholders. For example, founders could get a side letter guaranteeing their shares will convert to preferred shares upon reaching milestones. This allows founders to gain liquidation preferences, dividends, and other rights unavailable to common shareholders.

• Get clarity on specific provisions - If any parts of the main financing documents lack clarity or leave room for disagreement, founders can get certainty and clarity via a side letter. For instance, if the terms around future funding are vague, founders could use a side letter to lock in a more definitive commitment or structure. Side letters provide an opportunity to clarify ambiguities and avoid disputes.
• Preserve working control - In certain cases, founders can use a side letter to carve out specific voting or board representation rights that help preserve their working control of the company. Ultimately, this helps protect against having the board or voting agenda dominated by the new investor.
• Attract investor interest - Some founders proactively offer side letters with preferential terms to attract investors to a deal, especially in competitive rounds. Side letters can help tip the scales for investors deciding between multiple possible deals.

Overall, side letters present opportunities for startup founders and executives to solidify their positions and gain important advantages during private equity negotiations. When used judiciously, they can help founders close unfavorable deals while preserving upside and control.

Potential Risks of Side Letters for Founders

Side letters can present some risks that founders should consider before agreeing to additional terms with investors.

Some of the potential risks associated with side letters include: 

Creating Two Classes of Shares

However, founders and fund managers should be cautious about side agreements as they may result in two categories of shares; one held by investors who are party to the agreement and another held by other shareholders. This arrangement can lead to rights, voting control, or economic benefits for some shareholders, which may cause conflicts if not addressed properly from the beginning of the fundraising process.

Giving Up Control or Governance Rights

In situations, investors can leverage side agreements to negotiate control or governance rights through provisions such as extra board seats, veto power over specific decisions, or increased voting authority. These provisions might diminish the significant amount of decision-making power or control held by founders and management. Consequently, founders should thoroughly consider their options before entering into any side agreement that could relinquish their rights.

Setting Bad Precedents

There is also a risk that agreeing to certain terms in a side letter could set a precedent for future funding rounds. Investors in subsequent rounds may expect to get the same special terms, or even expanded ones, through future side letters. This could reduce the leverage and negotiating power founders have in future deals.

Key Benefits of Side Letters for Investors

Here are some benefits venture capitalists and other investors can obtain through side letters. ;

- Extra control or information rights: One of the most common reasons VCs request a side letter arrangement is to negotiate additional rights and provisions beyond what is contained in the standard investment documents. For example, an investor may use a side letter to obtain an extra board seat, expanded information rights, or more voting rights than other shareholders. This gives the investor more control and visibility into the startup's operations.

- Competitive advantage to win deals: By offering more preferential treatment in side letter terms to founders, such as superior liquidation preferences or dividends, investors can make their deal terms more enticing than competing offers. This can be a strategic advantage for winning competitive deals, especially for prominent startups attracting multiple VC term sheets. The flexibility of side letters allows VCs to craft custom offerings to impress founders and edge out other bidders.

- Set expectations around liquidity events: Side letters enable investors to set clear expectations and terms around future liquidity events such as an acquisition or IPO. For example, the side letter could specify timing, structure, and valuation thresholds for a liquidity event acceptable to the investor. This gives the investor more influence over exit scenarios.

- Future funding commitments: An investor can use a side letter to negotiate the right to invest a defined amount of funds in future funding rounds for the startup. This gives the investor an advantage in maintaining their pro rata stake as the company raises additional private investment funds or capital.

Overall, side letters provide opportunities for investors to extract additional benefits, rights, and control levers beyond the standard investment documents. VCs strategically employ side letters to maximize their investment opportunities and position their investments in financing rounds. But founders should also carefully evaluate the implications of any proposed investments and side letter terms to protect their interests.

Potential Downsides of Side Letters for Investors

While side letters can provide benefits for investors, they also come with some potential risks that should be carefully considered:

Diluting the rights of other investors

• If not properly structured, the additional rights granted in a side letter can dilute the rights of other investors in the deal. It is especially the case if the side letter terms are kept secret from all participants.
• For example, granting extra board seats, voting rights, or liquidation preferences to one investor reduces what is available to others. This may devalue their investment or reduce their ability to influence the company.
• Investors should think carefully before negotiating side letter terms that could dilute or disadvantage other stakeholders. This can lead to disputes down the line.

Complicating the cap table

• The preferential terms granted in a side letter effectively create a separate class of shares, thus complicating the capitalization table.
• If not documented properly, it may be unclear to future investors which shareholders have which rights. This makes future financing rounds more difficult.
• Side letter arrangements should be carefully drafted alongside lawyers to ensure proper documentation. They should also be disclosed to all relevant parties to avoid confusion.
• Too many side letter agreements can complicate the cap table, creating administrative headaches for the company. Investors should use them judiciously.

Best Practices for Negotiating Side Letters

When employing a side letter, both founders and investors must adhere to practices that mitigate risks and ensure an understanding of the terms. Here are some recommended guidelines;

- Be transparent about the terms of the side letter provisions and their implications. Communicate the purpose of the side letter provisions and their potential impact on the financing round and parties involved. Avoid trying to gain advantages through obscure side letter provisions and terms quietly.

- Only use a side letter when necessary to clarify specific provisions. Don't introduce side letters speculatively or unnecessarily. Side letters should address narrowly defined issues not fully covered in the main financing documents.

- Get proper legal counsel to review the side letter. Have an experienced startup lawyer examine the side letter terms to ensure the implications are fully understood. Verify the side letter aligns with the main agreement, financing documents, and company interests.

- Reference the existence of the side letter in the main financing documents. Don't try to hide the fact that a side letter exists in fund documents. Disclose its existence and purpose in fund documents so all parties know the supplementary terms.

- Ensure all stakeholders agree to the side letter terms. Seek approval not just from directors but all affected shareholders. Unilateral side letter arrangements could dilute or disadvantage other investors.

Following these best practices helps establish trust between founders and investors. Both parties should feel the side letter transparently provides necessary clarifications.

Alternatives to Using Side Letters

Rather than using a side letter agreement, companies and investors have a few other options for handling special terms or clarifications in investment:

Amendments to Main Documents

- If the additional terms apply to the partnership agreement between all parties, they can be added directly to the main partnership agreement or financing documents through an amendment. This avoids having a separate side agreement.

- However, this can be more complex if the special terms only apply to certain investors or limited partners. Amending the main offering documents only for a subset of parties may not be feasible.

Rely Solely on Main Documents

- A side letter may not be necessary if the main documents already allow flexibility in certain areas through negotiated provisions.

- For example, if the docs give broad discretion on board appointment rights, an additional side letter may not be needed to grant an extra seat.

Separate Shareholder Agreement

- In some cases, a standalone shareholder agreement between the company and one or more investors may be used instead of a side letter.

- This is a more formal, limited partnership agreement that can address special governance terms, voting rights, ROFR provisions, etc.

- May be better suited for complex special terms that apply to multiple later-stage investors.

Rather than complicating the cap table with side letters, companies should aim to handle special terms through clearer main document drafting or formal shareholder agreements when necessary. Side letters should be reserved for urgent clarifications or minor terms.

Frequently Asked Questions About Side Letters

Are side letters legally binding?

Yes, side letters are subject to the law and legally binding contracts if properly executed by authorized signatories from both parties. The terms of a side letter have the same legal rights as the main financing documents.

Who needs to agree to the side letter terms?

Typically, all major investors in the financing round would need to agree to the side letter terms, especially if the fund's primary contract or side letter grants specific rights or benefits to certain investors. Having agreement from all key parties prevents disputes.

What terms are commonly addressed in side letters?

Some of the most common terms in side letters include:

• Liquidation preferences or dividends
• Board seats and voting rights
• Future funding commitments
• Information or reporting requirements
• Drag-along, tag-along, and other control rights
• Clarifications around specific provisions in the main documents

Do side letters dilute other investors?

Sometimes, side letters can create two shares with differing rights. If not properly disclosed, this could dilute the rights of other investors. Care needs to be taken to ensure fair treatment.

When are side letters requested?

Side letters are commonly requested for larger, later-stage rounds where investors want to negotiate specific rights or benefits. They are less common in early-stage seed rounds with standardized offering documents.

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