Angel Investor Side Letters: When To Use One

Should your angel investor's extra rights sit in a side letter, or should they go into your shareholders agreement?

Usually, a side letter can work well when the rights are specific to one investor and don't need to change the rules for everyone. But if the right affects how all shareholders are treated, how shares are issued, or how major decisions are made, it's often better handled in the shareholders agreement or constitution.

This doesn't have to be complicated. The main thing is making sure the documents fit together, so you don't accidentally promise one thing in a side letter and something different in your company documents.

What Is An Angel Investor Side Letter?

An angel investor side letter is a separate agreement that gives one investor extra rights or clarifies terms that aren't fully covered in the main investment documents.

In an early stage raise, your main documents usually include:

• a subscription agreement or share application document
• a shareholders agreement
• your company constitution, if you have one beyond the replaceable rules in the Corporations Act 2001
• board or shareholder approvals for issuing shares
• ASIC filings after the share issue, such as updating share structure details within the required timeframe

A side letter sits alongside those documents. It doesn't replace them. It usually deals with a smaller set of rights between the company and one investor, or sometimes between the founders and that investor.

For example, Maya runs a Melbourne SaaS startup and is raising $250,000 from several angel investors. One investor is a former CFO and wants quarterly financial reporting and a right to maintain their percentage in the next raise. Maya doesn't want to reopen the shareholders agreement for every investor. A carefully drafted side letter could be a neat way to document those specific rights, provided it doesn't conflict with the shareholders agreement.

When Should You Use A Side Letter Instead Of Changing The Shareholders Agreement?

You should usually use a side letter when the extra rights are personal to one investor and don't need to apply to everyone.

Side letters are common in startup investment rounds because early raises move quickly. You might have a standard shareholders agreement for all investors, but one angel investor brings something extra to the table, such as strategic introductions, industry expertise or a larger cheque.

A side letter may make sense where the investor wants:

• extra information rights, such as monthly or quarterly reporting
• a confidentiality undertaking from the company about how investor information is handled
• a pro rata right to participate in future funding rounds
• a board observer seat, without becoming a director
• a right to be consulted before certain decisions, without having a formal veto
• a most favoured nation style right, meaning they can access better rights later offered to similar investors

It may be better to amend the shareholders agreement where the right changes the rules for all shareholders, such as:

• pre-emptive rights on new share issues
• rights of first refusal if shares are sold
• tag-along or drag-along rights
• reserved matters requiring investor approval
• vesting arrangements for founders
• share transfer restrictions
• company-wide confidentiality and restraint obligations

The practical test is simple: if the right affects the company as a whole or changes how other shareholders' rights work, keep it in the main company documents. If it's a private arrangement with one investor and can operate without affecting others, a side letter may be suitable.

What Rights Usually Go In An Angel Investor Side Letter?

The most common side letter rights are information rights, confidentiality obligations, pro rata rights and observer or consultation rights.

The right mix depends on the stage of your startup, how much the investor is putting in, and what role they're expected to play after completion.

Information Rights

Information rights give an investor access to agreed business information at agreed times.

For an angel investor, this might include:

• monthly management accounts
• quarterly financial updates
• annual budgets
• cash runway updates
• board packs, with sensitive items removed if needed
• notice of future fundraising plans

From a founder's perspective, be careful not to overpromise. If you agree to deliver board-level reporting every month before you have a finance function, you'll create admin pressure and may fall behind.

A practical side letter should say what will be provided, when it will be provided, and whether the company can withhold information where disclosure would breach confidentiality, privacy obligations or legal duties.

Confidentiality Rights

Confidentiality terms should protect both sides, especially where sensitive company information is being shared outside the board.

Your side letter should cover:

• what information is confidential
• how the investor can use that information
• who the investor can share it with, such as accountants or advisers
• how long confidentiality lasts
• what happens if disclosure is required by law or a regulator

If your startup handles personal information, your privacy obligations may also matter. The Privacy Act 1988 and Australian Privacy Principles can affect how you collect, use and disclose personal information. Even if your business isn't yet covered by the Privacy Act, investors will often expect you to treat customer, employee and product data carefully.

Pro Rata Rights

A pro rata right gives an investor the chance to invest more in a future round so they can maintain their ownership percentage.

For example, if an angel owns 5% of your company, a pro rata right may allow them to buy enough shares in the next round to stay at 5%, rather than being diluted.

These rights can be founder-friendly if drafted clearly. You can set sensible limits, such as:

• the right only applies to equity financing rounds, not employee share issues
• the investor must respond within a short offer period
• the right doesn't apply to strategic investors or accelerator arrangements
• the company can exclude the investor where doing so is required to comply with fundraising laws

Pro rata rights should also match any pre-emptive rights in your shareholders agreement. If they don't, you may end up with two different processes for the same share issue.

Board Observer Or Consultation Rights

A board observer right lets an investor attend board meetings without becoming a director.

This can be useful where the angel investor has experience you value, but you don't want to give them a formal board seat. The side letter should make it clear that an observer:

• doesn't vote at board meetings
• isn't counted in quorum
• must keep board materials confidential
• can be excluded from parts of meetings where there's a conflict or sensitive issue

Directors have duties under the Corporations Act, including duties to act with care and diligence, act in good faith and avoid improper use of position or information. A board observer usually won't have the same legal role as a director, but the boundaries should still be clear.

How Does A Side Letter Work With Your Shareholders Agreement?

A side letter should work with your shareholders agreement by filling gaps, not contradicting it.

This is where many startups run into trouble. A side letter may look short and simple, but it can create real tension if it cuts across your main documents.

For example, your shareholders agreement might say all new share issues must be offered to existing shareholders on a pro rata basis. If your side letter gives one angel a stronger right to participate ahead of others, you may be breaching the shareholders agreement when you try to honour the side letter.

Your documents should answer these questions clearly:

• Which document wins if there's a conflict?
• Does the side letter bind only the company, or also the founders?
• Do other shareholders need to consent to the side letter?
• Does the side letter end if the investor sells their shares?
• Can the rights be transferred to another person or entity?
• Does the side letter need to be disclosed to future investors?

Many side letters include a clause saying that if there's an inconsistency, the shareholders agreement prevails. That can help, but it isn't always enough. If the side letter right can't practically operate because of the shareholders agreement, the investor may not be getting what they think they're getting.

It's also worth checking your company constitution. If your company is relying on the replaceable rules under the Corporations Act instead of a tailored constitution, you may need to think about whether your investment structure is ready for outside investors.

What Should Founders Watch Out For Before Signing?

Founders should watch out for rights that limit future fundraising, create unequal treatment problems or put too much operational burden on the business.

Angel investment can be a great step for your startup, but a side letter should help the relationship work smoothly, not make future rounds harder.

Be especially careful with:

• Consent rights: If an investor can block too many decisions, you may lose flexibility to run the business.
• Information rights: If reporting obligations are too detailed, your team may spend too much time preparing investor updates instead of building the company.
• Most favoured nation rights: If you offer better terms to a later investor, you may have to upgrade this investor's rights too.
• Side deals about valuation: Promises about future discounts, valuations or anti-dilution protection can create issues in later rounds.
• Confidentiality gaps: If sensitive information can be shared too widely, you may expose customer data, trade secrets or commercial plans.
• Transferability: If rights can be transferred with the shares, you may end up owing special rights to someone you didn't choose.

You should also consider fundraising compliance. Under the Corporations Act, companies offering shares may need to provide a disclosure document unless an exemption applies. Startups often rely on exemptions such as small scale offerings, sophisticated investor certificates or offers to professional investors, but the details matter. A side letter shouldn't be used to sidestep those rules.

There are practical company steps too. If you issue shares, you'll need the right approvals, an updated members register and ASIC updates. For a proprietary company, you also need to keep an eye on the 50 non-employee shareholder limit.

What Should Angel Investors Check Before Asking For One?

Angel investors should check that the side letter rights are enforceable, practical and consistent with the company's main documents.

If you're investing your own money into an early stage company, it's completely reasonable to want visibility and some protection. The key is to ask for rights that are clear enough to rely on and realistic enough for the startup to manage.

You may want to check:

• whether the company has a shareholders agreement, investor rights agreement and constitution
• whether the side letter is signed by the right parties
• whether the company has authority to grant the promised rights
• whether the rights survive a future funding round
• whether your rights end if your shareholding drops below a set percentage
• whether you can share information with your professional advisers
• whether any confidentiality obligations are workable for you

If your investment is small, a long list of special rights may not be commercially sensible. If your investment is large or you're bringing strategic value, a side letter may be a fair way to document the extra role you're taking on.

One point that often gets missed is whether the side letter should be disclosed to later investors. Future lead investors may ask to see all side letters before completing a priced round. If a side letter contains unusual rights, it can slow down due diligence or create pressure to amend earlier agreements.

How Do You Put A Side Letter In Place?

You put a side letter in place by agreeing the extra rights, checking the main documents, getting the right approvals and signing it at the same time as the investment documents.

A sensible process usually looks like this:

1. Map the rights: Write down exactly what the investor is asking for and whether each right is personal to them or should apply to all shareholders.
2. Check the shareholders agreement: Look for conflicts with share issue, transfer, confidentiality, information and investor consent provisions.
3. Check the constitution: Make sure the proposed rights don't clash with the company's governance rules.
4. Confirm fundraising compliance: Check which disclosure exemption or process applies to the offer of shares.
5. Get approvals: Arrange board approvals and, if needed, shareholder approvals before shares are issued.
6. Sign at completion: Have the side letter signed at the same time as the share subscription letter or subscription agreement and other completion documents.
7. Update company records: Update the members register and complete any ASIC notifications required after the share issue.

Side letters are often short, but they still need careful drafting. A template may not pick up conflicts with your shareholders agreement, or the way a future funding round is likely to work. Documents work best when they're tailored to your company, your raise and the investor relationship you're trying to build.

Key Takeaways

• An angel investor side letter is useful when one investor needs specific rights that don't need to apply to everyone.
• Common side letter rights include information rights, confidentiality protections, pro rata rights and board observer rights.
• Your side letter shouldn't conflict with your shareholders agreement, constitution or fundraising obligations under the Corporations Act.
• Founders should avoid side letter terms that make future fundraising harder or create too much admin for the business.
• Angel investors should check that the side letter is signed by the right parties and that the rights will still work in later rounds.
• Getting the documents aligned early can help you avoid messy investor disputes as your startup grows.

If you'd like help with your investor side letter, shareholders agreement, fundraising documents or company approvals, you can reach us at 1800 730 617 or team@sprintlaw.com.au for a free, no-obligations chat.