Side Letters in Venture Capital Financing: Drafting and Negotiating, Implications on Future Financing, Potential Traps

Description

Side letters allow startups to negotiate specific terms with individual investors that are outside of the main financing and governance agreements. This allows a great deal of flexibility for both the start-up and investors because the terms of the side letter can be tailored to accommodate the unique circumstances or strategic objectives between the parties. While both private equity and venture capital investors use side letters, in private equity, side letters often focus on accommodating large institutional investors with complex regulatory requirements. In venture capital transactions, side letters are more likely to include terms that allow investors to actively participate in a startup's management and development.

One of the most common forms of a side letter is a management rights letter (MRL), which allows the investor to participate in or substantially influence the conduct and management of the startup company. Other frequently requested rights for side letters may include participation or pro rata rights in future financing, board representation, more favorable liquidity terms, lower fees, greater transferability rights, enhanced information rights, and more lenient indemnification obligations.

It is important for counsel advising a startup to carefully review the rights granted to investors in a side letter as the terms can have the potential to negatively impact the startup's future financing, sale, or exit strategies. Investors should consider the inclusion of a representation or statement from the startup that the obligations agreed upon in the side letter have been authorized by all the necessary parties and do not conflict with the company's obligations and duties under its governance documents.

Listen as our authoritative panel discusses the role of side letters in venture capital financing, highlights recent trends in the use of side letters, and provides guidance for advising startups and investors on implementing these agreements as part of their venture capital financing strategy.