What is an Investor Side Letter?
Often, when conducting a private offering raise, there comes a time when a key group of investors demand terms that are more favorable to them, relative to the other investors. Common sense dictates that there should be some mechanism to accommodate those investors, provided their demands don’t unfairly prejudice the other investors. But how to do that without overriding the entire offering structure?
Enter the “Side Letter”. This is essentially an investor agreement that permits some deviations from the core terms of the offering, in exchange for investment. This is very common in the hedge fund context, but is used in startups and other businesses as well. The minimum best practice in order to facilitate this approach, is to disclose the possibility of side letters in the private placement memorandum. There are numerous other best practices in connection with using side letters. Some key considerations include confidentiality of the agreement, so as not to create discord among the other investors, as well as making the side letter contingent on the investor performing its end of the obligation. In addition, the issuer may want to impose certain ongoing conditions as to the obligation to provide superior terms (e.g., the subject investor holds a certain amount of equity). Finally, great care has to be taken to assure that the superior terms that the particular investor receives are not so material or so out of balance with the core terms of the offering that you are inviting an investor lawsuit.
The operative language indicating what the investors received in the side letter arrangement featured in the link above is below. Essentially, that issuer provided a select group of investors the opportunity to appoint a board member to the company, provided that investor maintained a certain equity stake in the company:
Contemporaneously with the execution and delivery of this Agreement, the parties hereto are executing and delivering a (i) Registration Rights Agreement, substantially in the form attached hereto as Exhibit B (the “Registration Rights Agreement“), pursuant to which the Company has agreed to provide certain registration rights with respect to the Registrable Securities (as defined in the Registration Rights Agreement) under the 1933 Act and the rules and regulations promulgated thereunder, and applicable state securities laws, and (ii) Side Letter, substantially in the form attached hereto as Exhibit C (the “Side Letter “), pursuant to which and pursuant to the Certificate of Designations, Hale, as long as it together with any of its Affiliates hold Preferred Shares convertible into at least 5% of the outstanding Common Stock of the Company on an as converted basis, shall have the right to designate one (1) director for election to the Board of Directors of the Company (the “Board“) and shall have observation and committee representation rights, all as set forth in such Side Letter.