Side Letter

What is a side letter?

‍A side letter is a supplementary written agreement, typically between a company and an individual investor, that records specific rights, undertakings, or commercial terms in addition to the standard investment documents executed by all parties to a funding round. Side letters sit alongside the main subscription agreement, shareholders' agreement, and constitution, and they are used to capture bespoke arrangements that the company is not willing to extend to every investor or that an individual investor needs for their own internal reasons.

‍Side letters are particularly common in venture capital fundraising rounds where the lead investor and follow-on investors negotiate a single set of standard terms, but specific funds, family offices, or strategic investors require additional protections or undertakings. Common subjects covered in side letters include enhanced information rights, the right to attend board meetings as an observer, most-favoured-nation provisions that pull through better terms granted to subsequent investors, transfer restrictions, regulatory representations, and confirmations needed for the investor's own fund constitution or compliance framework.

‍For Irish founders, a side letter can be a pragmatic tool for closing a funding round without needing to renegotiate the standard terms of the round each time a new investor raises a unique requirement. Used carefully, it allows the company to satisfy investor-specific needs while keeping the core deal documents consistent across the cap table. Used carelessly, it can create a patchwork of overlapping commitments that become difficult to track and may give some investors substantially better economic or governance rights than others without proper transparency.

When are side letters used?

‍Side letters appear most frequently when a fund or institutional investor needs particular representations, warranties, or covenants to satisfy its own limited partner agreements, regulatory commitments, or internal investment guidelines. For example, a US fund may require specific tax representations to avoid adverse treatment under its own structure, an ESG-focused fund may require ongoing reporting commitments, and a strategic investor such as a corporate venture arm may require confidentiality undertakings, rights of first negotiation on commercial deals, or specific consent rights over future strategic transactions.

‍They are also used to grant specific governance rights to lead investors that are not extended to all participants in the round. A common example is a board observer right that allows a fund to send a representative to board meetings without taking on the full statutory duties of a director. Information rights such as monthly management accounts, quarterly board materials, or detailed budget access are also frequently granted by side letter to specific investors above a defined investment threshold.

‍Most-favoured-nation clauses are another common use case. An investor concerned that a later investor in the same round, or in a future round, may receive better terms can negotiate a side letter giving them the right to elect any such better terms. These clauses need careful drafting to specify which terms are within scope, how the election is made, and how it interacts with the company's flexibility to do future fundraising.

Risks and pitfalls for founders

‍The biggest risk with side letters is loss of cap table coherence. Each side letter creates obligations that the company must continue to honour, and these obligations may interact with the rights of other shareholders in ways that are not immediately obvious. A side letter granting a specific investor approval rights over certain types of transaction can effectively give that investor a veto, even where the shareholders' agreement does not provide one to investors generally.

‍Side letters are also typically subject to confidentiality, which means other shareholders may not know what has been agreed. This can become an issue at later fundraisings, where new investors expect full disclosure of all material agreements affecting the company. Failure to disclose a side letter during due diligence can derail a transaction or lead to indemnity claims after closing.

‍Watch out for cumulative effects. Granting one investor an information right by side letter, another investor a board observer right, a third investor a most-favoured-nation right, and a fourth investor a consent right over commercial decisions can result in a governance structure that is unwieldy and inconsistent with the formal corporate governance set out in the board of directors and shareholders' agreement.

Practical tips for negotiating side letters

‍Keep a master register of all side letters, recording the counterparty, the date, the key obligations, and any expiry or termination triggers. This register should be maintained by the company secretary and reviewed regularly by the board of directors, particularly before any future fundraising or commercial transaction that might be affected by the commitments.

‍Resist creep. Each new fundraising round will bring fresh side letter requests from new investors, and existing investors will sometimes seek to refresh or expand their existing side letters. Push back on requests that overlap with the standard documents, that grant rights inconsistent with the rights of other investors, or that materially restrict the company's operational flexibility. The most effective response is often to incorporate genuinely useful provisions into the main shareholders' agreement so that all investors get the benefit, rather than maintaining a parallel set of bilateral commitments.

‍Finally, get experienced legal advice. The drafting of side letters is technical and the implications of poorly drafted clauses can be significant. Founders should not sign side letters without their company solicitor reviewing the language and explaining the practical effect, particularly for clauses dealing with most-favoured-nation rights, consent rights, transfer restrictions, and information undertakings.

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