The Hidden Pitfalls of Side Letters in Venture Financings
By Thomas Earnest and Jacob Neumark
Nearly every venture financing produces a set of core documents: an amended charter, a stock purchase agreement, an investors’ rights agreement, a voting agreement, and a right of first refusal and co-sale agreement. Those documents are negotiated by the company and the lead investor and apply to everyone in the round, and often to existing investors as well. Often, though, an individual investor asks for something extra, such as a management rights letter or another type of side letter. Some of these terms serve a genuine regulatory purpose: a management rights letter, for example, helps a fund qualify as a “venture capital operating company” and avoid being subject to ERISA’s plan asset rules. Many others, however, are simply sweeteners offered to secure an investor’s participation in the round.
Side letters are short, bilateral agreements between the company and a single investor. They typically grant rights the investor could not get, or did not want to ask for, in the main documents: pro rata participation rights, enhanced information rights, a board observer seat, a most favored nation clause, or permission to use the company’s name and logo in marketing materials. They feel like a small accommodation at the time. That is exactly the problem: a side letter is easy to sign and very hard to unwind, and the ones signed at the seed stage tend to shape every round that follows.
Below are the pitfalls that come up most often, and what founders can do about them.
Pitfall 1: Side letters are far harder to amend
The main financing documents are designed to be amended. Each generally permits changes with the approval of the company and a requisite percentage of holders, so terms can be adjusted over time with majority support rather than unanimous consent. A side letter sits outside that structure. Because it is a standalone agreement with one investor, amending or terminating it usually requires that investor’s consent, no matter how small the position becomes or how misaligned the term grows with later rounds.
In practice, a right granted in a side letter is permanent unless the letter itself says otherwise. Negotiate accordingly, and resist the temptation to over-grant in order to close quickly.
Pitfall 2: Side letters set precedent
Side letters are not private. Investors in later rounds routinely request copies of all existing side letters during diligence, and the current NVCA model Stock Purchase Agreement calls for their disclosure. When later investors see a right granted to an earlier investor, they often expect the same treatment. Because Seed documents become the template for the Series A, and the Series A documents become the template for the Series B, a side letter granted in the first priced round travels forward, surfaces in each subsequent diligence process, and gets cited by each new investor. Most favored nation clauses amplify the dynamic: they can automatically extend new, better terms to prior investors, creating a ratchet that only moves in one direction.
A single accommodation can quietly become the company’s baseline. Before granting a right to one investor, assume every future investor will ask for it and decide whether the answer would still be yes.
Pitfall 3: Standalone rights lock an investor in permanently
Financing documents usually reserve the most meaningful rights, such as pro rata participation, detailed information rights, and rights of first refusal and co-sale, for investors who meet a defined “Major Investor” threshold. That threshold is dynamic by design. As the company raises larger rounds, the threshold is typically raised, and investors who do not continue to participate fall out of Major Investor status. The system rewards investors who keep supporting the company.
Granting those same rights directly in a side letter breaks that mechanism. The investor holds them permanently, regardless of future ownership and regardless of whether the investor ever invests another dollar. If the goal is simply to make sure a particular investor qualifies today, the better route is usually to set the Major Investor threshold in the financing documents at a level that includes them. A threshold set in the documents serves as a reference point in later negotiations without locking the company into anything.
Practical tips for founders
Evaluate requests holistically, not one at a time. First decide whether the accommodation is warranted at all. Only then decide how to deliver it, whether through an adjustment to the financing documents or through a narrow side letter.
Define “Major Investor” by a fixed ownership percentage rather than dollars invested or a share-count threshold. In practice, this shifts the rights towards a “pay to play” model, where if investors don’t continue to participate in future rounds, they may lose their status as the company issues new shares.
Reserve side letters for genuinely investor-specific items. Consent to use the investor’s name or logo, or a fund-specific regulatory or reporting provision, belongs in a side letter. Core economic and governance rights generally do not.
Build in sunsets. Rights in a side letter will generally terminate on a sale of the company or on the initial public offering. Consider, though, whether the side letter should terminate on the next qualified financing or when the investor’s holdings fall below a stated level.
Make rights personal and non-transferable, so they do not follow the shares into the hands of a secondary buyer.
Limit most favored nation clauses tightly, or avoid them. Carve out rights granted for regulatory or administrative reasons, and cap the scope of what can be swept in.
Conclusion
Side letters are a legitimate and sometimes necessary tool. They become a problem when they are treated as a convenient way to close a round rather than as permanent amendments to the company’s capital structure. The discipline is to ask, each time, whether the right belongs to this investor specifically or to a class of investors generally, and whether the company will still be comfortable with that answer three rounds from now. Asking early costs very little; answering late can cost a great deal.