Side Letter

A side letter is a separate agreement granting a specific investor terms or rights different from those given to other investors in the same round. Also used between a VC fund and one of its LPs, side letters accommodate investor-specific requirements such as enhanced information rights, lower fees, tax-related representations for tax-exempt investors, restrictions on certain investment activities, or other bespoke provisions, without modifying the main financing documents that apply to all investors. Side letters are the mechanism by which differentiated investor relationships get formalized while keeping the primary deal documents uniform.

The common uses in venture financing:

• Enhanced information rights for a specific large investor (more frequent reporting, additional financial detail).
• Tax-related provisions for tax-exempt investors (pension funds, endowments) requiring representations the company won't engage in UBTI-triggering activities.
• Co-investment rights for specific investors who want first look at follow-on rounds beyond standard pro-rata.
• ESG or impact reporting for investors with specific reporting needs.
• Most-favored-nation provisions that give a specific investor any better terms granted to subsequent investors.

The common uses in VC fund formation:

• Reduced management fees for early or strategic LPs (a 1.5% fee instead of 2%).
• Reduced carried interest for certain LPs.
• Co-investment rights allowing LPs to invest directly in portfolio companies alongside the fund without management fee or carry on those direct investments.
• Excuse provisions allowing LPs to opt out of investments that conflict with their policies.

The MFN trigger risk: most-favored-nation clauses in earlier side letters can be triggered by later side letters with better terms, automatically extending the better terms to earlier investors. Founders and fund managers consistently underestimate how MFN provisions create cascading obligations across the investor base. The disclosure requirement: some side-letter terms must be disclosed to other investors, depending on the financing documents and applicable law.

Ryan's Take

Side letters are the mechanism by which "we all signed the same deal" turns out to be untrue. The lead investor signs the documents that bind everyone; the strategic CVC signs the same documents plus a side letter giving them right of first negotiation on acquisition; the family office signs the same documents plus a side letter on enhanced information rights. Each individual side letter seems reasonable; the cumulative stack of them can create unexpected obligations on the company. Track side letters carefully, watch for MFN triggers, and don't grant any side-letter right without modeling who else might also be entitled to it.

What founders get wrong: Granting side-letter terms casually without considering MFN implications. A side letter giving Investor A reduced management fees can automatically extend to Investor B if Investor B has an MFN clause in their earlier side letter. The cascading effect can erode fund economics quickly. Track side-letter terms and their MFN implications carefully.

Related: [MFN Clause] · [Investor Rights Agreement] · [Subscription Agreement] · [Limited Partner]

FAQ

What is a side letter? A separate agreement between the company and a specific investor (or between a VC fund and one of its LPs) granting terms or rights different from other investors in the same round. Used to accommodate investor-specific requirements without modifying the main financing documents that apply to all investors.

Why do investors negotiate side letters? To get specific accommodations that don't fit in the standard documents: enhanced information rights, reduced fees, tax-related representations for tax-exempt investors, co-investment rights, excuse provisions for specific investment types, MFN clauses. The main documents stay uniform; the side letter handles the bespoke arrangement.

What's the MFN risk in side letters? Most-favored-nation provisions in side letters automatically extend any better terms granted to later investors back to the earlier MFN-protected investor. A 1.5% fee granted to a later LP can cascade through multiple earlier MFN-protected LPs, eroding fund economics. Track MFN implications carefully before granting any side-letter terms.