You have just agreed on a term sheet. The lead investor’s lawyers have sent through the subscription agreement, the shareholders’ agreement, and the company constitution amendments. You are reviewing the documents, negotiating the details, and getting ready to close. Then a participating investor — perhaps a smaller fund, a corporate venture arm, or an angel syndicate — sends through a separate document: a side letter.
If this is your first encounter with a side letter, you might be tempted to treat it as a minor administrative addendum. That would be a mistake. Side letters are binding contracts that sit alongside your main financing documents, and the rights they grant can materially affect your company’s governance, your ability to raise future rounds, and your options at exit.
This article explains what side letters are, why investors ask for them, what provisions Australian founders should expect to see, and where the risks lie.
What Is a Side Letter?
A side letter is a short, standalone agreement between your company and a single investor that grants that investor specific rights or privileges beyond what is contained in the primary financing documents. In a priced round, the primary documents are typically the subscription agreement, the shareholders’ agreement, and any amendments to the company constitution. In a convertible round, the primary document is the SAFE or convertible note.
The defining feature of a side letter is that it creates a bilateral arrangement. Unlike the shareholders’ agreement, which binds all parties and is typically amended only with the consent of a specified majority of shareholders, a side letter binds only the company and the requesting investor. This has an important consequence: because no other investor is a party to the side letter, the rights it contains can generally only be amended or waived with the consent of that specific investor.
Side letters are usually short — one to three pages — but their brevity should not be confused with insignificance.
Why Investors Ask for Side Letters
Investors request side letters for a range of reasons. Some are routine and compliance-driven. Others are commercial and strategic.
Regulatory compliance. Institutional investors — particularly those that manage capital on behalf of superannuation funds, university endowments, or government-backed programs — may be subject to regulatory obligations that require them to secure certain contractual rights from every portfolio company. In Australia, a fund that holds investments on behalf of a registrable superannuation entity may need to demonstrate adequate governance and information access for compliance with the Superannuation Industry (Supervision) Act 1993 (Cth) and APRA’s prudential standards. In the US, funds with pension plan investors subject to ERISA have similar requirements. These side letters typically request consultation rights, inspection rights, and access to board materials — and they are largely non-negotiable.
Filling gaps in the primary documents. Sometimes a side letter is used because a specific right does not fit neatly into the shareholders’ agreement or would be inappropriate to grant to all investors. For example, a lead investor who is not taking a board seat may want board observer rights, or a strategic corporate investor may want notice of any acquisition approach. These provisions are investor-specific by nature and are better addressed in a side letter than in a document that applies to the entire investor base.
Securing additional commercial rights. This is where founders need to pay the most attention. Some investors use side letters to negotiate rights that go beyond what the round’s standard terms provide — and that they could not have secured if those rights had been subject to negotiation with the full investor group. Common examples include enhanced pro rata rights in future rounds, information rights that would not otherwise apply given the investor’s check size, or consent rights that give the investor a unilateral veto over certain company actions.
Common Side Letter Provisions
The specific provisions you see will depend on the stage of the round, the type of investor, and the norms of the Australian venture market. Here are the most frequently requested:
Pro rata rights. The right to participate in future financing rounds on a pro rata basis — that is, to invest enough to maintain the investor’s percentage ownership. In a priced round, pro rata rights are often already included in the shareholders’ agreement for “major investors” above a specified investment threshold. Side letters are used by investors who fall below that threshold but still want the right to follow on.
Information rights. A commitment by the company to provide the investor with regular financial statements, management accounts, or other business updates. Again, these rights are often already available to major investors under the shareholders’ agreement. A side letter extends them to a smaller investor who would not otherwise qualify.
Board observer rights. The right to attend board meetings as a non-voting observer and to receive copies of all board papers and minutes. This is a common request from investors who are active and engaged but whose check size does not justify a board seat.
Most favoured nation (MFN) clauses. An MFN clause provides that if the company grants more favourable terms to any other investor in the same round (or in a subsequent convertible round), those same terms will automatically be extended to the investor holding the MFN right. MFN clauses are particularly common in SAFE rounds, where Y Combinator’s standard post-money SAFE no longer includes an MFN provision by default — meaning investors who want one must negotiate it separately.
Major investor status. A commitment that the investor will be treated as a “major investor” in the next priced round, entitling them to the full suite of rights typically reserved for larger investors, regardless of their actual investment amount.
Strategic investor rights. Corporate venture capital arms and strategic investors frequently request rights that relate to a potential sale of the company — ranging from advance notice of any acquisition approach to a right of first refusal to match a third-party offer. These provisions can have a significant chilling effect on M&A interest if not carefully scoped.
Anti-dilution or ratchet protections. Less common in the Australian market than in the US, but some investors request bespoke anti-dilution protections that go beyond the standard broad-based weighted average adjustment included in the shareholders’ agreement.
The MFN Problem
MFN clauses deserve special attention because they can turn a single concession into a round-wide obligation.
Here is how it works. You agree to give Investor A a side letter with enhanced pro rata rights. Investor B has an MFN clause in their own side letter. Investor B is now entitled to elect the same enhanced pro rata rights — even though you never negotiated that with them directly.
The practical effect is that every side letter concession you make to any investor is potentially available to every other investor who holds an MFN. This creates a cascading dynamic where a small concession to one investor becomes a material change to your cap table economics.
If you are going to accept MFN clauses — and they are standard enough that you may have limited room to refuse — you should insist on two things. First, carve out any provisions that are specific to a particular investor’s regulatory or compliance needs, so that a compliance-driven side letter does not trigger MFN elections for commercial rights. Second, consider including a threshold requirement so that the MFN only applies to investors at or above a specified commitment size.
How Side Letters Interact with Australian Financing Documents
In the Australian venture market, the shareholders’ agreement is the primary governance document for a priced round. It typically contains amendment provisions requiring the consent of a specified majority of shareholders — commonly a majority of preferred shareholders, or a combination of founder and investor consent. These amendment provisions are a safeguard: they ensure that no single investor can unilaterally change the deal.
Side letters sit outside this framework. Because a side letter is a bilateral contract between the company and one investor, the rights it contains are not subject to the shareholders’ agreement’s amendment provisions. The investor effectively has a veto over any change to their side letter rights, because the company cannot amend the side letter without that investor’s consent.
This is the core structural issue with side letters: they allow individual investors to extract rights that are protected from the collective governance mechanisms that apply to the shareholders’ agreement. A right that would be subject to majority investor approval if it were in the shareholders’ agreement becomes a unilateral entitlement when it is in a side letter.
Under the Corporations Act 2001 (Cth), the company’s obligations under a side letter are contractual and enforceable in the same way as any other commercial agreement. There is no specific statutory regime governing side letters in venture transactions. However, founders should be aware that side letter obligations — particularly consent rights or restrictions on company actions — can interact with directors’ duties under sections 180 to 184 of the Act. If a side letter restricts the company’s ability to act in a way that the directors consider to be in the best interests of the company, there is a tension that needs to be managed.
Side Letters in SAFE Rounds
Side letters are arguably even more common in convertible rounds than in priced rounds, because the simplicity of SAFE and convertible note instruments means they often lack the detailed governance provisions found in a shareholders’ agreement. There is no investors’ rights agreement, no voting agreement, and typically no information rights framework.
Investors who want any of these protections in a SAFE round must negotiate them separately — and a side letter is the standard mechanism for doing so. Common SAFE side letter provisions in the Australian market include:
- Pro rata rights in the next equity financing
- MFN rights to match more favourable terms offered to later SAFE investors
- Information rights (monthly or quarterly financials)
- Board observer rights during the pre-Series A period
One important practical point: Y Combinator’s post-money SAFE removed the MFN provision that was included in the earlier pre-money SAFE. The rationale was that the post-money SAFE’s valuation cap already accounts for dilution from future SAFEs, so an MFN is unnecessary. Not all Australian investors agree with this logic, and many will request an MFN side letter alongside a post-money SAFE.
What Founders Should Watch For
Not all side letter requests are created equal. Here are the provisions that should prompt careful consideration:
Consent rights over company actions. Any provision that requires the company to obtain an individual investor’s consent before taking a specified action — such as raising capital, entering into a material contract, or changing the business plan — gives that investor a unilateral veto. These rights are powerful and can be difficult to manage operationally, particularly if the investor becomes unresponsive or adversarial.
Right of first refusal on acquisitions. A ROFR that allows a strategic investor to match any third-party acquisition offer can deter potential acquirers from engaging in the first place. If you agree to a ROFR, insist on a short exercise window and clearly defined triggering events.
Super pro rata rights. A right to invest more than the investor’s pro rata share in a future round — effectively allowing the investor to increase their ownership percentage — dilutes other investors and can create friction with your lead investor in the next round.
Perpetual rights. Ensure that side letter rights are limited to the current round or the next financing, rather than applying indefinitely. A pro rata right that applies to “all future financings” is a significantly greater concession than one limited to the next equity financing.
Advisory shares or additional equity. Requests for equity outside the round’s pricing — typically framed as advisory shares or success fees — should be treated with scepticism. They dilute existing shareholders and are not standard practice in the Australian market.
Practical Guidance for Founders
If an investor requests a side letter, here is how to approach it:
Read it carefully. Do not treat a side letter as boilerplate. Every provision is a binding obligation.
Assess proportionality. Weigh the rights being requested against the size of the investor’s check and the value they bring — capital, expertise, network, or strategic alignment. A $2 million lead investor has a stronger case for enhanced rights than a $50,000 participant.
Consider the MFN cascade. Before agreeing to any provision, ask whether other investors in the round hold MFN rights that would entitle them to elect the same provision. If so, model the impact as if every MFN holder will exercise.
Limit scope and duration. Push for side letter rights that are limited to the current round or the next financing, and that terminate on a defined event — such as the closing of the next priced round or the investor’s ownership falling below a specified threshold.
Get legal advice. Side letters interact with your shareholders’ agreement, your constitution, and your directors’ duties. The interplay is not always obvious, and the consequences of getting it wrong can be significant.
Side letters are a normal part of venture financing. They are not inherently problematic, and many of the rights they contain are reasonable and well-understood. The risk lies in treating them casually — in agreeing to provisions without understanding their implications, or in allowing side letters to accumulate across rounds until the company’s governance becomes a patchwork of bilateral obligations that no single document captures.
If you are raising capital and want to ensure your side letters protect both the company and the investor relationship, get in touch.
