Side Letters in Fundraising

Founders navigating a down market in fundraising- especially first-time founders eager to secure any source of capital- can be susceptible to a lesser-known aspect of fundraising called 'side letters.' These additional stipulations often come into play during negotiations with potential investors and can appear harmless at first, but create complications for founders down the road.

What is a Side Letter?

A side letter is the colloquial term referencing an agreement or additional legal document that investors might request when signing a more standard agreement, like a SAFE (Simple Agreement for Future Equity). They include special rights and privileges reserved for the investor outside of the standard investment document.

Common Requests in Side Letters

On the surface, side letters may seem harmless. They're frequently used to request fairly innocuous things like information rights, access to meetings, and requests to speak to the CEO on a regular basis- small governance items that don't significantly impact how the company operates or implications on future fundraising.

However, some VCs may request more onerous terms, such as pro rata rights, super pro rata rights, or indefinite pro rata rights. These terms can complicate matters for founders as they go out to raise in the future. Even so, this may not pose a significant problem if the founder knows the request is coming and has enough time to negotiate it.

Warning: Unexpected Side Letter Requests

The danger comes when VCs surprise founders with side letter requests late in the negotiation. This is an all-too-common scenario:

A VC is one of the last firms still in the running to a deal with a founder.The VC proposes their terms, and the founder agrees to proceed with them, proposing to write it up in a SAFE.The founder informs other firms in the process that they’re going with this VC.The shortlisted VC firm then says “Amazing… by the way, our standard practice whenever we do a deal with SAFES is to ask that you sign this a side letter.”

It's here that they drop more requests outside of the standard YC SAFE, like pro rata rights in future rounds. When this happens, the founder has lost leverage to negotiate or push back. It’s much harder to say “I only want to do what's standard in the SAFE” or, “I will be okay with X, but not Y. Let's make sure to strike those off” because they've told everyone else in the running that they're going with this firm.

Prevention: Ask About Side Letters Early On

My warning to founders as you’re nearing a deal, especially if you’re doing it around a SAFE and especially if you’re engaging with larger, more established funds, is to start asking about side letters. You may want to ask potential investors:

When you invest using a SAFE, do you typically request any additional terms or use side letters?If you do use side letters, what requests or clauses do you usually include?

By asking these questions, you can avoid getting blindsided by last-minute side letter requests that could put you at a disadvantage. It’s hard for first-time founders to know what to ask for, so remember this the next time you go out and raise on a SAFE and you start talking to investors. Don’t get stuck the same way I’ve seen a lot of founders get stuck in this market.

Takeaways

Be cautious of side letters: While they may often contain harmless requests, they can also introduce unexpected terms that put founders at a disadvantage.Ask about side letters early in negotiations: When discussing terms with potential investors, ask them if they typically use side letters and what requests they usually include.Maintain leverage during negotiations: Don't inform other potential investors that you've chosen a different firm until all terms, including those in side letters, have been thoroughly discussed and agreed on .Familiarize yourself with common side letter requests: Being knowledgeable about the types of requests VCs may include in side letters can better prepare you for negotiations.

Be chased,
Jason