Embarking on the funding journey for your startup involves navigating a complex web of legal agreements, and side letters are a crucial aspect often encountered in pre-seed and seed rounds. In this comprehensive guide, we'll delve into the intricacies of side letters, shedding light on key terms, negotiation strategies, and the critical role legal firms play in ensuring your startup's success.
A side letter is not just a casual “letter”; it's a legally binding contract between an investor and a startup, outlining additional rights beyond the main investment document. It comes into play when investors seek rights beyond the standard terms laid out in the primary investment agreement, whether during priced rounds, convertible notes, or SAFE rounds.
Side letters find application in various scenarios, which may include investments by larger investors or strategic investors when the investors feel that the main investment documents (whether such documents are in the form of a SAFE, convertible note, or a priced round) do not provide them with key terms that they are seeking in connection with their investment. For example, strategic investors, often customers, may request rights like being informed about a potential sale of the company. The negotiation dynamics, however, shift based on the startup's leverage in the funding negotiation.
Understanding the terms in side letters is crucial for startups to make informed decisions. Some of the rights commonly requested in side letters by investors can be (and should be) accepted, but some should be scrutinized more closely depending on the context and the specific rights requested by the investor.
One common category of rights requested in side letters is "management rights," which are generally essential for VC fund compliance. While compliance-related rights should generally be accepted, caution is advised when additional, non-compliance-related management rights are proposed and it may not always be readily apparent whether certain management rights requested by an investor are truly needed for their compliance.
Pro rata rights, also known as participation rights, grant investors the option to maintain their percentage in future fundraising rounds by investing more money in such future rounds. While pro rata rights may be acceptable in some cases, startups often can and should push back. For example, startups may consider only granting pro rata rights to the largest investors in the round and may work to limit those rights to only the next priced round and not any rounds beyond the next priced round. Granting pro rata rights to too many investors can significantly hinder future fundraising flexibility.
Information rights entail the obligation for startups to provide periodic updates to investors, usually consisting of financial reporting requirements but also could include cap table reporting and budget reporting. While larger investors may request more extensive information, startups should push back on excessive information demands, especially in the early stages and from smaller investors.
In some side letters in pre-seed SAFE or convertible note rounds, investors may request that they be guaranteed “Major Investor” rights after the priced round when their investment converts into stock. Major investor rights typically consist of information rights and pro rata rights, among others. While startups may, in some cases, need to accept granting such rights to larger investors, the better approach is to limit these rights at this stage if possible.
Granting board observer rights allows an investor to attend board meetings without voting privileges. Startups should limit this to larger investors (perhaps only for a lead investor who is investing a majority of the funds in the round) and for a defined and limited timeframe. Board director rights, a more advanced level of involvement where an investor is entitled to appoint a representative to be a voting member of the Board of Directors, are generally discouraged in pre-seed rounds.
Blocking rights, granting specific approval authority to an individual investor, are typically reserved for a class of investors in a priced round, not for individual investors in a pre-seed round. As such, startups should push back on any blocking rights as much as possible.
As mentioned above, some investors (often strategic investors) may request certain rights in the event that the company is planning to sell the company in an acquisition. These rights should be limited as much as possible, and if any such rights are granted it should be limited to only notice rights and not any right of first refusal or right of first offer.
Another point of negotiation with investors is how long the foregoing rights will last. Some of the rights may continue after the priced round when conversion of a SAFE or convertible note occurs while others will terminate upon conversion. In general, startups should try to limit these rights when they can do so.
Startups should strive for standardization in investor rights across the board, reserving special considerations for significantly large or strategic investors. The nuances in side letters require careful consideration, making legal counsel invaluable.
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