It is fairly common for startups to raise their first few investment rounds using a SAFE (Simple Agreement For Future Equity). You may then be asked to review a "side letter."
Usually, both parties know the side letter is coming, at the time of signing the term sheet. In rare instances, the term sheet is quiet, and late-arriving investors may request the side letter with additional terms and provisions that are not included in the main financing documents.
It’s important for founders to understand what side letters are, and how provisions included in them will affect their future deals and most importantly, their company going forward.
That’s why in this article we’ll break down:
- What is a side letter in startup financing
- Reasons for using side letters
- Common requests found in side letters
What is a side letter in startup financing?
A side letter is a document that is often used in venture capital (VC) transactions to address specific concerns or provisions that are not included in the main investment agreement. These letters are typically used to address issues related to governance, voting rights, board representation, and other matters that are important to the investors and the company being funded.
Reasons for using side letters in venture capital deals
Side letters can be a useful tool for venture capital investors and companies to document and clarify certain agreements or understandings that are not reflected in the main agreement. They provide a way for the parties to address specific issues or concerns in a more detailed and focused manner, and can help to ensure that the parties are aligned on key issues and that the terms of the main agreement are applied in the way that the parties intended.
While side letters can be useful in addressing specific concerns or provisions that are not included in the main investment agreement, it is important to carefully consider the terms of these letters and the potential implications for all parties involved.
In some cases, side letters may be used to favor one party over the other, or to create unintended consequences for the company or the investors. It is therefore important to consult with legal counsel and carefully review the terms of any side letters before entering into a VC transaction.
Common requests found in side letters from investors
Side letters can be used by both investors and the company being funded to clarify certain terms or to negotiate specific provisions that may not have been addressed in the main investment agreement. Here are some of the examples of what issues are typically addressed in side letters:
- Investors may request a side letter to address concerns about the company's management team or to negotiate more favorable voting rights. Investors often want to have a say in important decisions related to the company's operations, such as changes to the company's business plan or the appointment of new executives. A side letter can be used to negotiate the investor's voting rights and the circumstances under which they may be exercised.
- A common use of side letters in VC transactions is to address issues related to board representation. Investors often want to have some level of control over the company's decision-making process, and a side letter can be used to negotiate the number of board seats that the investor will hold and the terms under which they will serve. This can be particularly important for minority investors, who may not have as much influence over the company as the majority shareholders.
- Another common use of side letters is to address financial terms. For example, a side letter may be used to document the terms of a convertible note or to clarify the terms of a preferred stock investment. This can include provisions related to the conversion price, the valuation of the company, and other financial matters.
- Side letters can also be used to address issues related to the treatment of different classes of shareholders. For example, a side letter may be used to specify the rights and privileges of preferred shareholders, who typically have priority over common shareholders in the event that the company is sold or goes bankrupt.
- Side letters can also be used to address issues related to intellectual property and other legal matters. For example, a side letter may be used to document the terms of a license agreement or to clarify the terms of a joint venture arrangement.
Overall, side letters are an important tool in venture capital transactions, and can be used to address specific concerns or provisions that are not included in the main investment agreement. However, it is important to carefully consider the terms of these letters and the potential implications for all parties involved, and to consult with legal counsel before entering into a VC transaction.
Is your startup doing business in Northern Mariana Islands? Learn about registration fees, filing deadlines & naming requirements.