Are VCs democratic? In an ideal world, they should be. But some investors are just more equal than others. SyndiCat was faced with a special ask. Thankfully, he had the answer…
Welcome to the world of Side Letters – the private handshakes with special investors. These private handshakes are a result of investors becoming smarter as they recognize their negotiating power for the extra value they are bringing to the deal.
Side Letter – What is it Exactly?
A Side Letter is a supplemental agreement between the GP and a specific investor. Its role is to selectively override some terms or add additional terms to the standard investment docs.
Why are they such an important part of VC dealmaking these days? Simply because the standard Op Agreements offer one-size-fits-all terms but there are some investors bringing more value than others – through a bigger cheque size, or being the first, or being a marquee name that’ll attract more investors to the pot. So what are the most common special terms they may seek?
Key Side Letter Requests
1. The FOMO Insurance: Also known as the MFN (Most Favored Nation) Clause, states that if the GP were to offer better terms to another investor in the future, the new terms would automatically be offered to the MFN holder. That way, the MFN holder is insured against future dilution of their rights.
2. Enhanced Information Rights: Most SPVs provide for annual and important updates. However, some investors may request periodic calls with the founders, or financial audits, etc. They just need to know more!
3. Pro-rata Rights & ROFRs: Side Letters seeking first right to oversubscribe to a pro-rata or an ROFR (Right of First Refusal) that other fellow investors may be skipping, are about catching opportunities that others might be passing.
4. Fee Reductions or Carry Breaks: GPs are frequently willing to reduce their standard “2-and-20” (2% management fee and 20% carry) to get the deal across the finish line. At Propel(x), we have seen GPs offer Anchor Discounts of full waiver of management fees and a reduced 15% carry.
Side Letter Risks
Imagine each of octopus’ arms wanting the octopus to do something different! Managing one SPV is generally straightforward but managing one with multiple side letters tends to become such an octopus. They are administrative nightmares for GPs taking their attention from being more productive!
Another risk the Side Letters run is offering rights that the GP might not have the authority to fulfil. For e.g., a side letter asks for enhanced information that might be denied by an NDA.
Final Word
Side Letters require careful negotiations and a thorough subsequent administration. Blessed are the VCs that do not have to deal with them – but they are a reality of today’s VC funding. We bid you caution and good luck!
If you’re looking for more information, you are welcome to browse Propel(x) SPVs page. If you want to discuss starting your own SPV…
Cheers!
