What is a Side Letter?

Not all investors wish to be treated equally. Whether you’re a VC raising money for your fund or a startup founder negotiating with venture capital funds, you may find investors requesting specific rights or waivers that the other investors may not get. Should you grant those requests, the terms spelling out those additional rights, privileges, or obligations would be set forth in a separate contract known as a side letter agreement—so called because such documentation happens “on the side,” separate from the primary contract documentation.

While side letters (or at least requests for side letters) may be common, should you as a VC or a startup seeking financing acquiesce to such requests? There is no standard answer to this question. It all depends on the context—context we’ll provide in this article. We’ll go over common things investors ask for in side letters, as well as key considerations VCs and startups should think about before granting such side letter requests.

Typical Side Letter Agreement Requests

Investors that request side letter agreements are typically seeking to minimize their downside risk or ensure that the fund is being operated in a way that meets their unique needs (e.g., they may have special tax issues that need to be addressed). This leads to the common asks prospective limited partners (LPs) in a VC fund might have in side letter agreements:

• More Favorable Liquidity Terms. When one of the positions in a VC fund undergoes a liquidity event, the investors in the fund may be entitled to receive a distribution. However, some funds only pay out distributions after all positions have been exited. Investors may thus use side letters to request that their distributions be paid out after each individual liquidity event. While the benefits to investors are clear, agreeing to this may conflict with the fund's existing distribution waterfall or capital recycling model.
• Lower fees. Carried interest is typically 20% of remaining distribution value. However, some individual LPs—especially if they’re anchor LPs—may ask for a lower carried interest on their portion of the investment. On AngelList, we allow fund managers to do this within our system without needing to go through a side letter agreement.
• Greater Transferability Rights. Investors may ask to reduce restrictions surrounding their ability to transfer their stake in the fund to another party. This can help improve the investor’s liquidity, but also helps institutional investors transfer their investments among other investment vehicles with minimal friction. While these are common requests, it's important to confer with outside counsel to ensure that any potential transfer is only made subject to the terms of the LPA and applicable law.
• Enhanced Information and Reporting Rights. Investors may ask for more detailed—or more frequent—information and reporting than what the fund manager is required to provide to other LPs (e.g., custom financial report, audited financials, valuation data). This could add complexity to a fund’s operations. However, such requests could also be for straightforward compliance reasons (for instance, to comply with U.S. tax regulations, or because the LP reports to other regulators that require additional information).
• Excusal Rights. LPs may ask for the right to be excused from their funds being used for certain types of investments. Again, this could be due to compliance reasons—such as if the LP is another fund that has certain limitations on investment categories. However, catering for such carve outs can present substantial operational challenges to the fund manager, since most funds typically invest every LP's capital into investments pro ratably.
• Lighter Indemnification Obligations. In certain cases, indemnification costs—such as those stemming from legal action—may result in the LPs needing to pay in more capital to cover those costs. Some LPs may thus ask for a side letter agreement that would prevent the fund from doing so. However, doing so would then force other LPs to disproportionally fund such indemnification costs. Note this is a fairly uncommon term in a side letter agreement.
• More Lenient “Defaulting Partner” Terms. Should an LP fail to honor a capital call, they could be considered to be in default, subjecting them to certain penalties. Some LPs may thus ask for more lenient default language in such cases. However, this may again hinder the fund manager’s ability to efficiently manage the fund’s capital—not to mention putting the other LPs at a disadvantaged position. Note this is a fairly uncommon term in a side letter agreement.

Key Side Letter Considerations for VCs

A core tenet of venture capital is that almost everything is negotiable. So don’t be surprised if certain LPs approach you asking for additional rights via side letters. Whether you agree to such requests depends on several factors—such as how “in demand” your fund is, the potential size of the LP’s investment, and the relative bargaining power you have with your prospective LPs.

Here are a few questions you can ask yourself or your fund’s counsel when evaluating whether to grant a certain side letter request.

Would this side letter provision favor one investor at the expense of the others?

There are two categories of side letter terms. The first gives certain advantages to one investor but has no effect on the others. The second gives certain advantages to one investor—but only at the expense of the others.

Some VCs prefer to only grant side letter requests that fall into the first category. This could include things like lower carry as well as enhanced information and reporting rights. On the other hand, “category 2” requests could disadvantage the other investors. Examples might include those relating to more favorable liquidity terms, more lenient defaulting partner terms, and lighter indemnification obligations (Note: anything that meaningfully impacts an LP’s rights in a negative way would need to be included in an amendment to the limited partnership agreement).

How operationally feasible is this side letter?

Some side letter terms may not disadvantage the other investors—but they may create significant operational difficulties in managing the fund. This may include excusal rights, greater transferability rights, or enhanced information and reporting rights. Side letter obligations usually last for the duration of the fund, which can be 10+ years, and in some cases side letter provisions survive dissolution of the fund. Tracking and complying with certain obligations for over a decade can require significant time and resources.

There may be associated costs you can charge to the fund from LP capital, or costs that need to be paid out of pocket from the management company. Complying with side letter agreements might also require additional third-party support (lawyers, software providers, auditors, etc.).

How valuable is this prospective LP to my fund?

Supply-demand dynamics factor into every venture negotiation, and side letter requests are no different. Ultimately you have to weigh the value the LP may bring to your fund against any burden of agreeing to their side letter requests. For instance, if they’re an “anchor LP” that would not only contribute a large percentage of your fundraising target, but also attract other LPs to your fund, then their side letter request may be worth greater consideration.

What kind of MFN rights and carve outs are there in the Limited Partnership Agreement?

Most Favored Nation (MFN) clauses in an LPA essentially give every investor the option to enjoy the same benefits as the other investors (meaning that preferential terms granted in a side letter would not apply only to the LP in the side letter, but all LPs). More commonly, investors may ask for MFNs in their own side letters. In either event, the existence of an MFN then requires visibility to the additional entitlements other investors may have received via side letter agreements. While having an MFN in the LPA is relatively unusual, if LPs negotiate to have MFN clauses in their Limited Partnership Agreement (LPA) or as part of their own side letter, this may limit your ability to have side letter agreements with other investors.

However, not all MFN clauses are created equal. You could still include “carve outs” which would qualify or even restrict an investor’s right to enjoy similar benefits as other investors. Such carve outs could also be structured based on the size of an LP’s commitment to the fund. For instance, you could structure it so that MFN clauses only apply to LPs who contribute at least $2M to the fund.

Side Letter Best Practices for VCs

In addition to the guiding questions above, here are some best practices VCs can consider implementing when it comes to side letters.

• Think about how you would want to use side letters from the outset. Consider which LPs you would be most willing to grant side letters to, and what sort of rights you would be willing to give. Also consider the process for tracking all side letter obligations and MFN elections (where those with MFN rights elect whether they want to enjoy the benefits listed out in other side letter agreements).
• Keep side letter terms as standard as possible. Many VCs try to keep the language across all side letter agreements as consistent as possible to make compliance and monitoring easier. This will also make the MFN election process simpler. However, note that standard does not equal generic. Side letter provisions should also be made as specific as possible to keep obligations narrow.

How do VCs Use Side Letter Agreements?

As we mentioned earlier, VCs and VC funds investing in startups also commonly make use of side letter agreements during startups’ fundraising rounds. Usual asks include:

• Participation or pro rata rights. Typically comprises things like the right to be considered a major investor in future financings or a guarantee that they would be able to participate in future financings. This pro rata side letter by Y Combinator is a good example.
• Management consultation rights. May include the right to meet with the startup’s personnel to discuss operational and financial matters, or to advise the startup’s management.
• Information rights. The right to receive regular financial statements or other operational information from the startup.
• Board observer rights. The right to sit in and observe the startup’s board meetings.
• Waiver to other “standard” rights. An investor may ask that standard rights or obligations—such as drag along rights and rights of first refusal—if exercised by the other investors, not apply to them.

Key Considerations for Founders

The things founders should take into consideration before granting side letter requests to investors are similar to those of VCs facing side letter requests by prospective LPs.

Privileging one investor at the expense of the others may create conflict that hinders your fundraising ability—whether now or in the future. Providing certain side letter rights may be operationally difficult for your company. Some investors are worth more than others and thus might receive priority when it comes to side letter requests. And many financing documents contain MFN clauses.

Venture Capital Side Letters in Summary

Side letters may exist outside of the standard financing documents, but they’re a common feature in many VC deals. This extends to VCs raising a fund or startups obtaining VC financing. As such, both VCs and startup founders should be prepared. Understanding the typical provisions asked for in side letter agreements—and then coming up with a plan beforehand to deal with them—is crucial to ensure a smooth fundraising process.