Do Side Letters Actually Matter?

Here’s a dirty little secret from the world of startup investing: a lot of the time, side letters don’t matter.

Investors ask for them. Founders sign them. Lawyers file them away. And then the moment they’re actually supposed to do something, they don’t matter.

What is a side letter anyway?

Say an investor puts $100K into your startup. If things go well, they want the chance to put in a lot more later.

So on top of the SAFE, they ask you to sign a separate letter that says they get to invest more down the road. That’s an example of a side letter. It’s a supplemental agreement that sits alongside your main investment documents. A side letter can be about anything though. It doesn’t have to be about future investment rights. It could even be that every Saturday you will take your hippocorn wings and flap them to the nearest ice cream store to buy your investors cookies and cream ice cream. (My fav but I digress…) It is whatever you both mutually agreed to that is in addition to the SAFE.

The most common ask is for pro rata rights.

Say an investor puts in $50K and now owns effectively 1% of your company. You raise more money, new shares get issued, and his/her stake shrinks. A pro rata right lets him/her invest in that next round to buy back up to the original 1% stake. So pro rata rights do not give the investor free shares, but in a highly contested round where so many people want to invest, this right allows the prior investor to invest in the round to maintain stake.

(Note: the standard Y Combinator SAFE doesn’t include pro rata rights by default, which is why investors request it separately in a side letter at the time of the initial investment.) Sometimes follow on rights in a side letter are more specific. Maybe it’s the ability to invest $300K at the next priced round.

Anyway, you sign it. The investor signs it. Fast forward a year. The company is doing super well. A Series A firm comes along with a term sheet.They’re the only firm offering one. Then the Series A investor says: “We’ll invest, but only if you waive all the side letters you’ve signed and let us take the whole round.”

The founder says okay. Now the founder goes back to the early investors with follow on rights and asks them to sign documents cancelling their side letters.

The earlier investors are shocked. They thought they were legally protected. And they were.

The problem is that the terms have now changed because the leverage has changed. If the earlier investors do not agree to this, then the round may not happen. And the startup really needs the money.

So the early investors don’t get their follow-on opportunities. And they are probably ticked off (pardon my Hippocorn French) because they think they had a deal. So poof! A piece of paper signed at pre-seed magically disappears.

Let’s rewind the clock

So, before you decide how to handle a situation like this, it helps to know what everyone’s motivations are.

Even though side letters can span a whole range of asks, let’s just follow this example for the moment because follow-on requests are one of the most popular side letter requests.

In this case, the early stage investors take on some level of risk by writing the first check. But once it’s obvious it’s a great company, they also want to jump on the clear economics too.

If a company is growing fast, having the option to put more money in is obviously good for their investors. And, more ownership strengthens the relationship. An investor with a bigger stake prioritizes your company over the others sitting in their portfolio. Attention follows ownership.

And, many LPs love getting the chance to invest directly at later stages. Funds that can pass those opportunities along to their LPs have something valuable to offer and look good.

Most founders have no visibility into any of this. Honestly, it isn’t a founder’s job to sit around worrying about what investors care about. You have a company to build.

But it’s worth understanding.

Who actually holds the power here?

Although you might think it is the series A investor in this case, it’s actually the founders who do.

Once a startup is clearly working, later stage investors swarm. Even though only one term sheet was presented clearly that one investor really wanted to invest - so much so that they wanted the whole round.

This means a founder has leverage. If a founder pushes back and says “I want my seed investor in this round,” the larger fund almost always acquiesces. They want to invest in your company. Only you can decide who’s on your cap table.

So if you’re thinking about signing a side letter, have a conversation with your investor first. Why does this investor want to invest more later? Why should they be allowed to? What are they going to do between now and then to earn it?

Hustle Fund asks for side letters in a lot of cases, and the letter itself is mostly a forcing function. It gets a real conversation on the table at a moment when both sides are paying attention.

So it’s less about any actual letters, but about the intent around the side letters and the asks around waiving a side letter. In the meantime, I intend to fly to the nearest ice cream store to get cookies and cream.