What is a side letter in a startup investment?
Written by For Founders Law, a Toronto firm licensed by the Law Society of Ontario. About us
Short answer
A side letter is a separate agreement giving one investor rights beyond the main investment document, such as pro rata rights, information rights or a board observer seat. Side letters are common in SAFE rounds, where everyone signs the same form. They're binding contracts, so later investors and their lawyers will ask to see every one.
Why use a side letter?
Because the main document is standard. In a SAFE round, every investor usually signs the same SAFE. If one investor negotiates something extra, it goes in a side letter rather than a custom SAFE, so the main terms stay identical and easy to model.
In priced rounds, most investor rights sit in the shareholder agreement, but side letters still appear for investor-specific points, such as a fund’s regulatory requirements.
What do side letters usually cover?
| Right | What it gives the investor |
|---|---|
| Pro rata rights | The right to buy into a future round to keep their percentage |
| Information rights | Regular financial statements, budgets or updates |
| Board observer | A seat at board meetings without a vote |
| MFN | The right to adopt better terms given to later investors in similar instruments |
| Approval or consultation rights | A say on certain decisions |
| Fund-specific terms | Rules a fund has to follow, such as reporting or restricted activities |
Y Combinator publishes a standard pro rata side letter for use with its SAFE.
Are side letters binding?
Yes. A side letter is a contract between the company and the investor. Breaching it can lead to a claim like any other contract. If it gives the investor rights over how the company is managed, consider whether it interacts with the board’s duties or with any unanimous shareholder agreement under section 146 of the CBCA or section 108 of Ontario’s Business Corporations Act.
How do side letters interact with MFN clauses?
Carefully. If earlier SAFE investors have an MFN, they may be entitled to rights you give later investors in side letters, depending on how the MFN is worded. One generous side letter can spread across the whole round. Read every MFN before you offer anything new.
What happens to side letters at the priced round?
That depends on the letter. Many SAFE side letters end when the SAFE converts, or when the investor’s rights are replaced by the new shareholder agreement. A pro rata side letter, like Y Combinator’s, is exercised in the priced round itself, so it needs to be dealt with in that round’s allocation. The new lead’s lawyers will want every side letter terminated or folded into the new documents. See what is a term sheet?
How do I keep track?
Keep a list with your cap table: investor, date, rights given, when they end. Store the signed letters in the data room. Forgotten side letters are a common due diligence surprise, especially information rights or MFNs given to an early angel.
Should I agree to a side letter?
It depends on the right and the investor. Information rights for a meaningful investor are common. Broad approval rights, or pro rata for very small cheques, can make later rounds harder. Model the effect before you sign.
Our SAFE round work starts at $2,600; the number of side letters moves the price. See fees.
This guide is general information about Ontario and Canadian law, not legal advice for your situation. To review a side letter before you sign, book a free 15-minute consult.