When you invest in a venture fund, you might not be doing so on the same terms as every other investor (also known as “limited partners” or “LPs”). Some LPs condition their investment on getting a side letter agreement from the fund, which affords that LP special rights beyond those granted to other investors in the fund. 

These side letter agreements can impact all of a fund’s LPs in ways that might not be initially apparent. In this guide, we’ll provide an overview of side letters: what they are, how they work, and the role they play in venture deals.

What is a Side Letter?

In the context of venture capital funds, side letters refer to written agreements between a fund and its LP that afford said LP special rights, privileges, and obligations outside the standard limited partnership agreement (LPA) that all investors agree to. These arragements get their name from the idea that the agreement happens “on the side” (i.e., separate from the LPA).

Side letters have broad applications across finance, although the usage of side letters varies from fund-to-fund in the context of venture capital. Some fund managers will accept a side letter in order to attract a big ticket investor or because an LP requires it, while other fund managers prefer to have all investors participate in the fund on the same terms. 

Why Are Side Letters Used in Venture Capital?

Oftentimes, side letters are a function of leverage or circumstance. Investors in funds may want side letters to protect them from downside risk. For example, an investor may request a side letter that allows them to receive distributions after every fund liquidity event, rather than having to wait until the fund winds down (which often takes 10+ years). 

Other times, investors need a side letter to comply with their own obligations. For example, an investor may request increased information rights because they need to be able to share additional information with their own investors.

Typical Side Letter Requests

The following are common terms LPs request in their side letters:

• Liquidity terms: As mentioned previously, some investors may request to receive distributions from investments in the fund’s portfolio before the fund has exited all its positions. This allows side letter investors to have capital returned while other investors have to wait until the fund wind’s down entirely. For the fund manager, granting distributions early can impact the distribution waterfall or their capital recycling plans.
• Lower fees: Fund managers typically charge a management fee (usually 2% of the fund size) plus carried interest on the fund’s profits (usually 20% after the fund’s investors’ principle is returned). However, investors with leverage may be able to negotiate a lower management fee or lower carry on their portion of returns. Investors may have the leverage to negotiate lower fees if they’re contributing a large portion of the fund’s capital. 
• Transferability rights: Transferability rights give an investor more flexibility to move their stake in a fund to another party with minimal friction.
• Reporting and information rights: Investors in a fund are typically entitled to some information on the status of the fund’s investments. However, through a side letter, an investor can request more in-depth information, such as audited financial statements or valuation data.
• Indemnification obligations: If legal action is ever taken against the fund, the fund’s investors may need to contribute additional capital to cover legal costs. Through a side letter agreement, an investor can be excused from having to contribute funds in this instance. 
• Defaulting penalties: If an fund’s investor fails to honor a capital call, they’d typically be considered “in default” and subject to penalties, as specified in the LPA. Through a side letter agreement, an investor can ask for lighter penalties or more leniency around how soon they have to honor a capital call.

As you can see, side letters can provide an investor with more incentives, but also make things more unfair for other investors in a fund (e.g., if an investor has a side letter agreement shieding them from indemnification costs, other investors would have to pay a disproportionate amount). 

Further, side letter agreements can create numerous logistical hurdles for a fund manager, such as when an investor requires more in-depth reporting. For these reasons, all side letter requests should be scrutinized for the costs and benefits they offer the fund. Investors without a side letter agreement should also inquire as to whether existing side letters with other investors can have a material impact on them. 

Side Letter Best Practices

While many terms are negotiable in VC, recognize that as an investor, what you can negotiate is a function of leverage. If a fund isn’t having any trouble raising capital, it’s less likely to agree to a side letter with a specific investor (unless a side letter is needed for compliance purposes). Fund managers will try to ensure they’re being as fair as possible to all of a fund’s investors while also giving the fund as much operational flexibility as possible.

Here are a few other considerations for investors regarding side letters:

• Review Most Favored Nation (MFN) clauses: A LPA will occasionally have an MFN clause that gives every investor in a fund the right to receive the same benefits as every other investor. This means that a side letter agreement with one investor would then apply to every other investor in the fund. More commonly, investors ask for an MFN clause in their own side letter to ensure their terms are on par with the terms negotiated in another investor’s side letter. 
• MFN “carve outs”: A fund manager may try to include a “carve out” in an MFN clause, essentially qualifying when the MFN kicks in. For example, a carve out may stipulate that the MFN only applies to investors who hit a certain threshold in terms of capital invested in the fund.
• Be upfront about your side letter needs: It’s usually in a fund manager’s interest to limit side letter agreements, or make them as standard as possible. As an investor, you should understand your negotiating leverage and also aim to not overburden the fund manager with your side letter requests, as this could make it less appealing to have you as an LP in the fund. 

Angel Squad Teaches Investors the Ins & Outs of Venture Deals

Side letters are common for investors investing in funds, as well as fund managers investing in startups (although the terms vary). If you want a closer look at how venture deals are negotiated and executed, consider joining Hustle Fund’s Angel Squad. Members of Angel Squad get privileged access to the inner workings of Hustle Fund, including reviewing Hustle Fund deals, and participating in investments themselves. If you’re interested in kickstarting your career in VC, visit our website.