For entrepreneurs, it’s very common to raise your first few rounds of funding using a SAFE. Then you are requested to review a “side letter.” So what’s a SAFE, and more importantly, what specific provisions do you need to pay special attention to in a side letter? We can explain the key points to note in this article.
Before we dive into the nuisances of a side letter, let’s first revisit what a SAFE is. The acronym stands for “Simple Agreement for Future Equity.” It was launched by the Y Combinator in 2013. The idea behind it is instead of having investors and founders negotiate the complicated legal terms on a one-off basis, we should all use a simple yet standard template where everything is considered to be pre-negotiated and agreed upon. All that the founders and investors need to agree on, pretty much, is the valuation. These days we mostly use “post-money valuation,” i.e., how much the company is worth AFTER the investor’s money goes into the company. According to the YC, this method gives the founders and investors “- the ability to calculate immediately and precisely how much ownership of the company has been sold.”
That sounds simple enough, right? Well, not so fast. Once you agree on the valuation and fill out the SAFE, and just when you think you are done, the investors will often present you with a “side letter.” A side letter usually contains provisions that you enter with this specific investor that is NOT part of the standard SAFE. Doesn’t this defeat the whole purpose of SAFE? You’d ask. Well, yes and no. While this does deviate from having a standard, pre-negotiated agreement among all investors, some investors do have legitimate concerns that they would like to address, which may not apply to others. So when you are reviewing the side letter, what provisions should you pay special attention to? Here are a few key ones.
1. Pro-Rata rights
This means the current investor has the right, but not the obligation, to participate in the company’s future rounds of financing based on their percentage of investment for this round. Per the YC SAFE guide, founders should consider carefully giving out this right. This means when the next round does happen you need to make sure you discuss and obtain a response from the current investor promptly, to plan for appropriate allocation for this investor. Some investors may not respond right away, sometimes intentional, but then after the round closes, demand to participate per this provision, which is then impossible to accommodate.
There are also other nuisances about this provision: for example, what happens if, although rare, this investor stops owning the SAFE rights? By logic, the right to participate in future rounds should also terminate, but if so, it should be specified as such. A middle ground would be to require the investors to at least own half of the SAFE before they can participate in future rounds.
This means a “Most Favored Nation” clause. While this term is commonly used in the supplier context (Apple is notorious for demanding it), in this context, it means if the investor obtains the MFN status, the founders are not allowed to give other investors more favorable terms. So let’s say you raise $1m from the first investor for a $10M valuation, but later on, you need to accommodate another investor the same $1M for an $8M valuation, you then must go back to the first investor, if he has an MFN clause, to change his valuation to $8M as well.
3. Major investor
Some investors may also request to be treated as a “Major Investor,” who tends to have a series of rights associated with that status, such as preemptive rights, pro-rata purchase rights (addressed above), tag-along rights, registration rights, information rights, rights of first refusal, etc. The same question then arises if the investor stops owning the SAFE, but would still have all these rights. Similarly, it can be resolved by specifying once the investor stops owning all or sometimes at least 50% of the SAFE, such rights are terminated as well.
4. Board rights
Some investors will ask for a board seat in the side letter. Again, founders should consider granting such rights very carefully. If you have heard of founders being ousted (e.g., Steve Jobs), oftentimes, it is because the founders no longer control the board. When the founders do raise the next round, the new investors will likely request board seats as well. While board seats can be given, it should be done with much thought and planning for the future.
5. Other rights
Investors may ask for other rights such as the ability to invest in competitors, the ability to assign the side letter to affiliate(s) of theirs, etc. While some of these requests are fair, the founders also need to control such rights with some parameters, such as the investor cannot share their confidential information with the competitor they invest in, for example.
Seems daunting? While the SAFE is designed to simplify the investment process, as you can see, things can get really hairy really quickly. But don’t worry, here at Trusli, we can connect you with the pro attorneys of fundraising for a very reasonable price! Founders shouldn't be left in the dark reviewing these terms on their own, or calculating the cap table without professional help. The investors clearly won’t! Reach out to us; we can help you with the SAFE and the side letter.