The Benefits and Pitfalls of Using Side Letters for Private Placements

While side letters can be helpful in securing key investments, it is imperative to fully understand their legal implications…

Side letters are frequently used to enter into legal agreements between private funds and investors. They can be used to alter the terms of a limited partnership agreement or even override certain provisions. While side letters can be helpful in securing key investments, it is imperative to fully understand their legal implications.  The discussion below can also be applied to capital funding for any start-up and for operating businesses doing subsequent equity raises or debt funding rounds.

What Is a Side Letter?

A side letter is an agreement between the fund and one specific investor that changes terms of the limited partnership agreement with regard to that one investor. In some cases, the side letters are necessary for the investor to proceed with the transaction. In other cases, they are a tool for the investor to negotiate a more favorable deal.

Side letters have been increasingly used in connection with early stage formation funding.  They are often needed to satisfy last minute requests, usually on the day or day before a scheduled closing pursuant to last minute thoughts or realizations by a marquee investor, a strategic investor, employees, or friends and family.  They are also utilized to satisfy the requests of limited partners to accommodate subsequent closings without amending the limited partnership agreement.

These side letter negotiations often get into topics such as fee limitations, rights of transfer of the securities being issued, excusal rights, rights of redemption and notice of redemptions by other investors. They may also address a number of other additional representations and warranties by the issuer that others may not have, such as due diligence or record and premises inspection rights, and more frequent and more detailed reporting obligations of the issuer to this investor.

What Are the Potential Advantages and Disadvantages?

Before agreeing to a request for a side letter, it is important to understand the advantages and disadvantages. The obvious advantage is that the investor will proceed with the investment. In many cases, investors request side letters just prior to closing, and, therefore, it can be tempting to acquiesce without fully weighing the risks. However, there are several issues to consider:

• Dueling obligations: When a fund manager enters into a side letter, there are now two sets of agreements to track in terms of compliance — the side letter and the limited partnership agreement. Managers with numerous side letters must be sure to have a process in place to monitor their obligations.
• Fiduciary duties to other investors: When the terms of a side letter impact other investors, such as providing preferred liquidity and information rights, fund managers must be careful to evaluate how it may impact their fiduciary duties. In such cases, the fund manager may be required to disclose the terms of the side letter to other investors.
• Impact on past/future investments: Management of the issuer should consider issues of practicality and the effect of disclosure on other future investors. Another concern is whether past investment or existing financing documents are affected, such as credit facilities or co-investment arrangements.
• Most favored nation investors: A prospective marquee or strategic limited partner may use a side letter to seek to negotiate “most favored nation” terms allowing for this investor to elect to receive benefits granted to other limited partners. These rights can be important, and often create burdens on the issuer. Management should be consulting with the issuer’s attorneys throughout the funding, and need to determine whether another investor’s terms fall within the most favored nation’s term before agreeing to it in a side letter.

Key Takeaway

Given the potential pitfalls, it is important to review any request for a side letter with legal counsel. An experienced attorney can help you negotiate a side letter that best serves your interests and protects your legal rights. Of course, it is equally important that all agreements to amend the terms of the limited partnership agreement are memorialized in writing and signed by both parties.  Management of all entities, fund managers, CEO’s and proprietors alike, should be careful to abide by disclosure requirements for any material changes that affect investors’ rights that are reflected in the side letter.

If you have questions, please contact us

If you have any questions or if you would like to discuss these issues further,
please contact Dan Brecher or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.