What Is a Side Letter in a Real Estate Syndication?
A side letter is a separate agreement between the sponsor and one investor that changes or adds to that investor's terms, such as a fee discount, extra reporting rights or a most favored nation (MFN) clause. Side letters are generally allowed in a private offering, but terms that would matter to other investors must be disclosed, and a side letter cannot override the operating agreement unless the operating agreement allows it.
Side letters are common in large private funds. In a single apartment syndication raised from friends and followers they are less common, but they come up as soon as one investor writes a much larger check than the rest. This guide explains what goes in them, when others must be told, and the risks. It is not legal advice.
What is a side letter?
The operating agreement and subscription agreement set the same terms for every investor in a class. A side letter is a short, separate contract with one investor that adds to or changes those terms for that investor only.
Investors who ask for side letters tend to be those with leverage: someone investing a large share of the raise, a family office, a retirement plan with its own rules, or an entity with legal or tax limits on what it can sign. A first-time sponsor may also be tempted to offer one to land an anchor investor early.
What terms show up in side letters?
| Term | What it does | Who it affects | Disclosure concern |
|---|---|---|---|
| Fee discount or rebate | Lowers fees charged on this investor's money | Sponsor's income; sometimes other investors' share | High: changes economics |
| Reduced promote | Gives this investor a bigger share of profits | Other investors and the sponsor | High: changes the waterfall |
| Extra reporting | Monthly reports, property visits or access to the books | Sponsor's workload | Low to medium |
| MFN clause | Lets the investor elect better terms given to others | Every later side letter | Medium: affects future deals |
| Transfer rights | Allows transfers to a trust, family member or affiliate | Operating agreement transfer limits | Medium |
| Regulatory or tax accommodations | Terms a plan, trust or entity needs to comply with its own rules | That investor | Depends on content |
| First look on the next deal | Early access to future offerings | Other investors in the next deal | Medium |
Whether a term is "material" is a judgment call for you and your attorney. A good test: would another investor want to know before deciding to invest?
Do other investors have to be told?
Usually something must be said. Two rules matter most.
Antifraud. Rule 10b-5 makes it unlawful to omit a material fact needed to make what you said not misleading. If your memorandum describes the fees and the waterfall as applying to everyone, and one investor quietly pays less, the description may be misleading. See Rule 10b-5 for sponsors.
Rule 502(b) in 506(b) deals with non-accredited investors. Rule 502(b)(2)(iv) requires the issuer, a reasonable time before selling to a non-accredited purchaser, to give a brief written description of any material written information about the offering that was provided to an accredited investor but not to that purchaser. A side letter is written information, so it can fall within this rule. See Rule 502(b) disclosure.
In practice, many sponsors say in the private placement memorandum that side letters may exist, describe the kinds of terms they may contain, and tell investors which terms were granted before the deal closes.
How does an MFN clause work?
A most favored nation clause lets an investor see the side letter terms given to others and elect to receive them too. MFN clauses usually have limits:
- Size tiers. The investor can elect only terms given to investors of the same or smaller size.
- Carve-outs. Terms given for one investor's legal, tax or regulatory needs are excluded.
- Election window. The investor must elect within a set number of days after seeing the list.
MFN clauses keep side letters from becoming a race, but they also mean every new side letter can spread to others. Track them carefully.
A made-up example: what a fee rebate costs
A deal raises $4,000,000. The sponsor's asset management fee is $60,000 a year, shared by investors in proportion to their equity. All numbers are made up.
Investor A puts in $800,000 (20% of equity) and negotiates a side letter rebating half of the fee on her share. Investor B puts in $600,000 (15%) and has an MFN clause covering investors of $500,000 or more, so B elects the same rebate.
| Line | Amount |
|---|---|
| Asset management fee | $60,000 |
| Investor A's share (20%) | $12,000 |
| Rebate to A (50% of her share) | -$6,000 |
| Investor B's share (15%) | $9,000 |
| Rebate to B (50% of his share) | -$4,500 |
| Sponsor's net fee | $49,500 |
The numbers check out: $60,000 minus $6,000 minus $4,500 equals $49,500. The other 65% of investors pay the full fee on their share. That difference is exactly the kind of fact they would want to know.
What are the risks of side letters?
- Fairness and conflicts. Investors who pay full terms may feel misled if they learn of a better deal later, even if nothing illegal happened.
- Conflicts with the operating agreement. A side letter that promises something the operating agreement forbids can create a dispute. Check that the operating agreement allows side letters and says which document wins. See the syndication operating agreement.
- Administration. Rebates and special rights must be tracked in the waterfall and distributions for years.
- Tax effects. Rebates paid through distributions can shift allocations among members. Ask the deal's CPA how to report them.
A cleaner path is an investor class: for example, a class with a lower fee for checks above a set size, open to anyone who qualifies and described in the documents. Everyone sees the same menu.
How DoorRaise fits in
DoorRaise helps sponsors raise equity for apartment buildings with 5+ units from their friends and followers under Rule 506(b) or 506(c). It prepares the standard offering documents, forms the LLC, files Form D and state notices, and verifies accredited investors for 506(c). DoorRaise does not draft side letters: any special term you agree with one investor is yours to document and disclose with your own attorney. Investors fund by wire into escrow at Enterprise Bank & Trust, an FDIC-insured bank. Fees are $1,500 to set up (non-refundable), $5,000 at closing (only if the deal closes) and $3,500 a year, with no percentage of the raise and no part of the promote.
Raise your apartment deal from the people who already follow you.
DoorRaise is built for apartment buildings with 5 or more units: one link for the deal, escrow until closing and a standard fee card.
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FAQ
Are side letters legal?
Generally yes, in a private offering, as long as they do not make your other disclosures misleading and do not conflict with the operating agreement.
Do I have to show the side letter itself to other investors?
Not always the letter itself, but material terms should be disclosed. In a 506(b) deal with non-accredited investors, Rule 502(b) requires a written description of material written information given to accredited investors.
What is the difference between a side letter and an investor class?
A side letter is private and specific to one investor. A class is part of the operating agreement and open to everyone who meets its terms.
Should a first-time sponsor offer side letters?
Be careful. A side letter can help land an anchor investor, but it adds complexity and can upset others. A disclosed class is usually simpler.
Can a side letter change the waterfall?
It can for that investor if the operating agreement allows it, and that is exactly the kind of term that must be disclosed.
Next step: read investor classes in a syndication to offer different terms in the open.
Sources
This article is general information, not legal, tax or investment advice. Talk to a securities attorney about your deal. DoorRaise is not a law firm, broker-dealer, investment adviser or funding portal.