Seed Fundraising — Term Sheet Problems Part 3 — Side Letters by@ashrust

Seed Fundraising — Term Sheet Problems Part 3 — Side Letters

Side letters are separate legal documents, that usually come in addition to a term sheet, and may contain clauses which can have a big impact on your company. Here are the common matters usually addressed in side letters and how they can affect your company in the future. Information rights means an investor has access to the company’s financial information (revenue, profits, costs, etc.) every quarter. Super Pro Rata grants an investor the right to buy a larger percentage of the company at a later stage. Code of Conduct asks your company to adopt policies which meet or exceed their standards on common issues in the workplace.
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Side Letters are separate legal documents, that usually come in addition to a term sheet, and may contain clauses which can have a big impact on your company. Here are the common matters usually addressed in side letters and how they can affect your company.

Information and Notification Rights

What it is: Usually requested by strategic investors, i.e. the major public companies in your industries. Information rights means an investor has access to the company’s financial information (revenue, profits, costs, etc.) every quarter. Notification rights means you must inform this investor of an acquisition offer, which you cannot accept for a predetermined time period (usually enough time for the investor to potentially provide a counter offer).

How it hurts: Although notification rights have the potential to trigger a bidding war for your benefit, the risk is that the investor can also use it to investigate one of your competitors. As the investor knows you can’t be bought by another acquirer without their knowledge. Information rights make it difficult for your company to control its own story to the investor. For example, during future fundraising discussions, if you had a downturn in profits due to a new product launch, the investor may not get excited because they’ve seen your financials out of context.

Super Pro Rata

What it is: This grants an investor the right to buy a larger percentage of the company at a later stage. Usually, it’s a larger percentage than their first investment bought and would be purchased during your next round of financing at whatever price is set by the lead investor. Thus, the investor can increase their stake in the company in the next round but doesn’t (usually) get a special price.

How it hurts: Most of the time this money will be a great momentum driver for your next fundraising round. However, if your round is very competitive or your new investors want to buy a large share of the company, then the team will experience additional dilution. For example, if InvestorA wants to buy 35% of the company and InvestorB has Super Pro Rata rights for 15%, for a total of 50%, then everyone will be diluted by 1/3; rather than just 1/4 if it was only InvestorA. Assuming 100 initial shares, 50% dilution: 100/150 = ⅔ still owned by team; 35% dilution: 100/135 = ¾ still owned by team. There is also risk if an investor with Super Pro Rata rights doesn’t invest in the next round, as that signals negatively to other potential investors.

Code of Conduct

What it is: As a part of the investment, your investor asks your company to adopt specific policies which meet or exceed their standards on common issues in the workplace such as: HR initiatives.

How it hurts: In almost all cases, these policies are helpful. However, problems can arise if they are not regularly communicated to the rest of your team. For example, if your company policy requires every open position to have a candidate from an underrepresented group be interviewed before a hire is made, the hire could be stalled until this requirement is fulfilled. This can cause internal friction and tempt circumvention of the guidelines, especially when it is a surprise.

Side letters are common part of the term sheet process in seed rounds. Make sure you understand the impact of the most prevalent terms and how they will affect your company in the future.

Disclosure: My fund (Sterling Road), asks for Super Pro Rata rights when making investments. You can view the full process here.

If you’re a B2B company at the seed stage looking for help, you can reach me at [email protected]

Thanks to Kaego Rust, Alec Barrett-Wilsdon, Eric Wiesen, Sean Byrnes and David Smooke for their help on this article.

Photo by Helloquence

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