By Paul B. Johnson and Aaron Sokoloff

It has become increasingly common in venture financings for investors to require the company to enter into “side letters” – i.e. separate agreements between the company and one particular investor, which are separate from the main investment documents that are signed by all of the investors. Side letters may provide a particular investor with some unique set of rights (for example, information rights beyond what the other investors are getting), or impose certain additional restrictions on the company’s activities beyond what the rest of the investors require (this sometimes happens when one investor is a bank or financial services company whose investments are heavily regulated).

While many side letters appear to be short and straightforward, they can create unexpected issues for a company in its future transactions and operations, as well as for the investors that are not receiving side letters.

Companies should consider the following issues when an investor asks them to enter into a side letter:

• Vetoes in Future Deals. The main stockholder agreements in a financing (typically in Investor Rights Agreement, a Voting Agreement, and a Right of First Refusal and Co-Sale Agreement) can usually be amended or waived by a subset of the investors. So, if the company needs to amend or waive one of these agreements as part of a future financing or other transaction, a small investor would typically not be able to hold up the deal by refusing to approve that amendment or waiver. Side letters, in contrast, are just between the company and a single investor. If the company needs to amend or waive it to complete a future transaction, the company will need to get that specific investor’s permission. Other investors who want the transaction to proceed may be surprised to find that a small investor has an effective “veto” right as a result of their side letter.

• Race to the Bottom.  If one investor requests a side letter, then the company will likely need to disclose this to other investors participating in the deal. If the other investors learn of the rights that this one investor is requiring in its side letter, some of them may ask for the same rights. This can result in a “race to the bottom” as each investor tries to ensure it is getting the same rights requested by every other investor.

• Administrative Difficulty.  At a practical level, the presence of side letters may make it difficult for the company and its counsel to keep track of its obligations. For example, if an Investor Rights Agreement provides certain information rights to the investors as a whole, but one investor is entitled to additional information under a side letter, the company may forget that it needs to comply with both agreements and therefore fall into breach.

From an investor perspective, the proliferation of side letters means that, when negotiating representations and warranties with the company, the investor may want a specific representation from the company as to whether any other investors are receiving side letters or benefitting from similar arrangements.  Because of the “race to the bottom” dynamic mentioned above, companies may have an incentive not to be forthcoming about the side letters in place with other investors, so investors may want to explicitly require the company to disclose that information.