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.
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.
This article is part of a series on Seed Fundraising.
1. When to Raise Money
2. How to Build a Deck
3. VCs vs. Seed Funds vs. Angels
4. How to Get a Meeting
5. How to Request an Introduction
6. How to Get Early Momentum
7. How to make a Good Pitch Great
8. The 5 Most Common Pitch Mistakes
9. Meeting Requirements
10. The Basics of Meetings
11. How to Handle an Angel Investor Meeting
12. Know these Numbers for your VC Meeting
13. 4 Investor Gotcha Questions
14. How to Follow-Up After an Investor Meeting
15. How to Close the Lead Investor
16. The 4 Stages of a VC Process
17. How to Raise a $2 Million Seed Round
18. Go from Investor YES to Cash in Hand
19. When Investors Say Yes but Mean No
20. When and When Not to Use an Investors Name
21. Stop Making These Common Fundraising Mistakes
22. How to Avoid Bad Terms that Kill Startups
23. What to do After Receiving a Term Sheet
24. Term Sheet Problems Part 1 — Money Talks
25. Term Sheet Problems Part 2 — Boardroom Blues
26. Term Sheet Problems Part 3 — Side Letters
27. 10 Traits of Successful Founders
Sterling Road invests in pre-seed B2B startups based in North America. Full process here: sterlingroad.com/process.
You can reach me here: ash@sterlingroad.com
Thanks to Kaego Rust, Alec Barrett-Wilsdon, Eric Wiesen, Sean Byrnes and David Smooke for their help on this article.
Photo by Helloquence
