Side letter: individual LP terms in a fund

Side letter — a bilateral agreement between a capital-raising company and an individual investor. It grants that investor individual terms in addition to the base document signed by all others: for a startup this is the term sheet together with a SAFE or preferred share issuance agreement, for a fund — the LPA, for an SPV — the subscription agreement. The logic is identical: the main document is common to all participants, while personalized terms are set out in a separate private letter.

The instrument originated in institutional funds in the mid-1980s, when the first anchor investors — large US pension funds and university endowments — began demanding terms different from the standard LPA. The idea proved so convenient that in the 2000s the format descended into venture rounds: angels and early VCs began signing side letters to SAFEs and preferred share rounds. Today it is a standard part of any deal where there is at least one investor capable of negotiating terms.

For a capital-raising company, a side letter is a compromise. On one hand, one investor receives more than the others. On the other — without this the anchor investor would not have come at all, and the round simply would not close. The art here is to find balance: give exactly enough to close the deal, but not so much that other investors, upon learning of the private terms, feel deceived.

Two typical configurations

The side letter format exists in two classic scenarios.

Startup and investor.Here the side letter accompanies a SAFE, convertible note, or preferred share issuance agreement. Typical content: right to proportional participation in future rounds (pro rata), expanded information rights, observer seat on the board of directors, right of first refusal on share sales by other shareholders, most favored nations clause (MFN). For founders this is a way to give the lead investor non-standard terms without changing the general term sheet and without disclosing these terms to other round participants.

A good example — early Uber and Airbnb rounds, where individual angels received side letters with pro rata rights in subsequent rounds. By IPO these clauses had turned into billion-dollar positions — precisely thanks to the private arrangement, not an open term in the term sheet.

Fund and LP.Here the side letter is an appendix to the LPA. Typical content: reduction of management fee and carry, right to opt out of specific investments (excuse rights), expanded reporting, priority in co-investments, MFN on other LPs' terms. For the general partner this is a way to close an anchor commitment without rewriting the LPA for all thirty investors who will come later.

Classic case — the first Blackstone and KKR funds in the 1980s. Anchors there were several large US pension funds whose side letters gave them a carry reduction from 20% to 15% and the right to exit deals conflicting with their investment policy. Without these terms the funds simply would not have existed — other investors came only after the anchor was closed.

The legal scheme is identical in both cases: the main document is signed by all, the side letter — only with one investor. It cannot create an advantage directly contradicting the main document: such a clause would destroy the entire structure, since it calls into question the LPA or term sheet itself. But one can adapt the deal economics, operational rights, and information disclosure terms for a specific investor — within limits that do not break the overall construction.

Typical clauses

Consider the clauses that appear most frequently. Half of them are economics, half are operational rights.

• Fee reduction and economics improvement.In the fund context this is a reduction in management fee (e.g., from 2% to 1.5%) and carry (from 20% to 15% or 10%). In the startup context — improved conversion terms: lower valuation cap, increased discount to the next round. Standard formula — a scale tied to commitment size: the more you invest, the better the terms.
• Right to proportional participation in future rounds (pro rata).Allows an investor to purchase a share in subsequent rounds proportional to their current stake. For early angels and VCs this is a key tool for maintaining position during dilution. Super pro rata — the right to buy more than the proportional share — is given rarely and only to anchor investors with corresponding check size.
• Priority liquidity and redemption right.In funds — priority in income distribution upon certain events (early liquidation, GP change, default). In companies — right to demand share redemption upon triggers: change of control, expiration of a certain period without IPO, revenue falling below an established threshold. Typically these are protective mechanisms triggered only in deviation scenarios.
• Right to opt out of a specific investment (excuse rights).Typical for investors with regulatory or political restrictions. Pension funds with special investment policies (prohibition on investments in weapons, tobacco, fossil fuels), sovereign funds with sanctions country lists, Islamic investors with sharia requirements. Excuse right allows such an investor not to participate in a specific deal while preserving their position in the fund as a whole.
• Expanded information rights.Quarterly financial reports instead of annual, access to portfolio company data, ability to request additional information on first demand. For startups — observer seat on the board of directors without voting rights. For funds — presence on the LP advisory board and access to management meetings.
• Right to audit and independent review.Access to company or fund books and records, right to appoint an independent auditor at one's own expense, right to conduct regulatory review. Such terms are usually received by investors who themselves work under strict regulation — state pension funds, university endowments, large insurance companies, for whom this is part of their own fiduciary obligations.
• Softening of interest transfer terms.Ability to freely transfer LP interest or shares within the investor's corporate group without obtaining consent from the company or GP. In demand among holding structures with dozens of affiliated funds and family offices structuring investments through different levels of trusts and SPVs.
• Limitation of liability.Establishing a maximum liability amount of the investor to the company or fund — usually tied to the size of the investment or its portion. Important for investors working with fiduciary obligations to their own beneficiaries: state pensions, charitable foundations, family trusts, insurance reserves.
• Priority in co-investments.Right of first offer on large fund deals — e.g., on all deals over $50 million. For a large LP this is a way to get additional exposure to the best assets without additional management fee. For the GP — a way to close complex deals where one fund is insufficient, without attracting outside co-investors.

How an investor protects against worse terms: MFN

The most favored nations clause (Most Favored Nations, MFN) — basic insurance for an investor signing a side letter. It guarantees: if the company or fund gives another investor more favorable terms for a comparable position, the current investor receives the right to choose those same terms. Without MFN the entire logic of the private deal works against the holder himself — someone who came later with a smaller commitment may receive a more favorable package and devalue the initial arrangement.

Standard configuration — tiered MFN: improved terms are available only to investors whose commitment size is not less than a certain threshold. Usual benchmark — not less than the investor receiving the benefit. This protects the capital-raising party from a situation where a small angel or LP automatically receives the terms of an anchor investor who invested ten times more.

MFN exceptions typically include several categories. First — regulatory exceptions: terms given to an investor due to their specific status (ERISA, state pension fund, sovereign fund, foreign investor in a US fund). Second — tax adjustments: UBTI management, ECI exemption, withholding relief on dividend payments. Third — rights related to commitment size: co-investment priority, advisory board seat, distribution priority. Everything else falls under MFN automatically.

In practice MFN works through a disclosure mechanism: the company or fund is obliged once per period (usually quarterly or upon closing each new investor) to inform all MFN holders of any new side letters indicating the terms contained therein. Holders receive a certain period, typically 30 days, to choose which of the new terms they want to adopt. Without a reliable disclosure procedure MFN becomes a decorative right impossible to exercise in practice.

Risks for the company or fund

Side letters do not exist for free. Their presence creates for the capital-raising party an entire set of operational, regulatory, and reputational risks.

• Fragmentation of terms.With thirty or more investors, each with their own side letter, the internal compliance function ceases to cope with tracking obligations. One investor receives reports monthly, another quarterly, a third has no access to data on certain portfolio companies. Execution errors become a matter of time, and each such error is a potential lawsuit from an investor whose rights have been violated.
• Breach of fiduciary duties.If one investor's terms unreasonably disadvantage the others — uneven distribution of investment opportunities, selective information disclosure, distortion of expense allocation among LPs — this is a direct path to litigation. In 2018 the Platinum Partners fund became a demonstrative example: a significant part of claims against its managers was built precisely on disproportionate and hidden side letters with individual LPs.
• Regulatory pressure 2023 onwards.The SEC's Private Fund Rules adopted in August 2023 required uniform disclosure of all preferential terms in side letters. Part of the provisions were overturned by an appellate court in 2024, but the trend toward transparency among US and European regulators has not gone anywhere. In the EU AIFMD II tightens requirements for disclosure of LP preferences — funds will have to either standardize terms or disclose the entire content of private agreements.
• Tax consequences.Return of part of the management fee to one LP may create constructive receipt of income for the others — they effectively receive additional income without actual payment. In the startup context non-standard terms may violate the unity of share issuance of one class and create problems with the IRS and Russian Federal Tax Service. Tax audit of side letters is a separate discipline with its own logic and typical errors.
• Reputational risks.If the content of side letters becomes known to other investors — and this happens more often than desired, since MFN mechanically forces the company to disclose terms to holders of corresponding rights — then those who did not receive them feel deceived. This directly impacts subsequent rounds and subsequent funds: potential LPs will demand in advance the same terms as anchors, and any negotiating reserve when attracting new capital disappears.

When a side letter is genuinely needed

In Private.law Attorneys' practice we recommend an investor request a substantive side letter only in three basic cases — in all other situations it loses economic sense for the investor and creates unnecessary administrative burden for the company.

1. Anchor investor.Commitment size significantly exceeds the round average and provides real basis for negotiation. Approximate level — 25% or more of total round size, or a significant part of the fund's first closing. Anchor status is the only case where a side letter is economically justified in terms of improving deal economics: carry reduction, pro rata, co-investment priority.
2. Regulatory exception.Investor cannot by law participate in certain types of deals or must observe certain procedures. Classic examples: ERISA investors with restrictions on plan assets share in the fund, state pension funds with industry prohibitions, sovereign funds with sanctions lists, sharia investors with restrictions on interest-bearing instruments. Side letter here is not negotiation but a matter of legal compliance, without which the investor cannot enter the deal at all.
3. Tax specificity.Investor has specific tax obligations requiring adapted terms. Foreign investor in a US fund needs ECI exemption and withholding relief on distributions. Charitable endowment — UBTI management. Large corporate investor may need specific expense allocation between structure levels. All these clauses do not change the overall deal economics but make it compatible with the investor's tax position — without them the deal is either impossible or economically unfavorable.

Beyond these three cases a substantive side letter loses economic sense for the investor and creates unnecessary burden for the company. Drafting, negotiation, subsequent execution and compliance can consume all the gains from non-standard terms — and then instead of a protection tool the side letter becomes a source of problems for both parties.

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