January 28, 2025
Venture Capital: Side Letters in Emerging & Growth Equity Financings
A recent Troutman Pepper Locke memo discusses some of the key issues associated with side letters entered into between VC investors and the portfolio companies in which they invest. The memo address three categories of rights that may be provided to a VC investor in a side letter: (i) rights that the company has already granted to existing investors, such as standard information and board observer rights; (ii) rights that the company has already granted to existing investors that could impact the other investors, such as preemptive rights, “major investor” status & carve-outs to drag-along provisions; and (iii) novel rights that no existing investors have been granted. Here’s an excerpt from the memo’s discussion of this last category of rights:
The last bucket is perhaps the most nuanced – granting novel rights via a side letter that no existing investors have been granted. For example, including a provision in a side letter that prohibits the company from using the investor’s name in press releases or other publications is likely not a material issue, but could the same be said about granting carve-outs to a drag-along provision that applies to all equity holders under the company’s governance documents? A drag-along provision is a provision in an agreement requiring all equityholders who executed such agreement to contractually agree to sell their securities on terms and conditions approved by the company’s board and/or a subset of its equityholders.
Assume an investor, via a side letter, negotiates certain carve-outs or conditions to the applicability of the drag-along against that individual investor while no other investors with the same class of security receives the benefit of such carve-outs or conditions. In those instances, in addition to investor relations considerations, both the company and the investor must consider whether the provisions in the side letter are enforceable, and the risks associated with them. If the parties are considering granting rights in a side letter that are substantive enough to be material to the company or potentially violate or contradict the governance documents, then the side letter may not be enforceable absent additional board and equityholder approvals to amend the applicable underlying governance document(s).
The memo also points out that certain items that are requested in a side letter may need to be set forth in the underlying governance documents in order to be enforcable, and cites carve-outs from certain transfer restrictions contained in governance documents as an example of a term that other investors might contend should be included in the governance documents themselves. In a situation like this, the side letter’s objective of saving time and expense by avoiding the need to reopen documents will no longer be served.
– John Jenkins