Navigating Participation Rights in Convertible Note/SAFE Side Letters

By Marc Ernaga, Partner

Convertible Notes and SAFEs: Simplifying Early-Stage Fundraising

Convertible notes and SAFEs (Simple Agreements for Future Equity) are popular financing instruments for early-stage startups because they provide a streamlined way to raise early funds. These instruments allow companies to secure capital quickly and efficiently without immediately needing to go through a formal, priced equity round. While these tools offer simplicity, investors often seek additional protections through side letters, with one of the most prominent rights being pro rata (or participation) rights in future equity financings.

Participation Rights: Protecting Ownership Through Conversion

Participation rights are important to investors because they protect their ownership stakes when convertible notes or SAFEs convert into equity. Typically, these instruments are subject to dilution during the equity financing round in which they convert. This is particularly the case when the SAFE includes a valuation cap. While the post-money valuation cap is meant to set a ceiling on the company’s valuation when converting the SAFE, it applies only to the money raised through the SAFEs — not to the equity financing itself (e.g., Seed or Series A). In other words, the post-money valuation is “post” all of the SAFE money, but it is not also “post” the equity financing money.

Because of this, even with a post-money SAFE, investors often face dilution when the equity financing occurs. To mitigate this risk, investors negotiate for pro rata rights in side letters, allowing them to participate in the equity financing and protect their stake from further dilution when new shares are issued automatically in connection with the SAFE conversion.

Y Combinator vs. Bespoke Side Letters

While Y Combinator’s pro rata side letter is widely used and considered balanced, many professional investors use bespoke side letters. Here are a few key areas where companies should be cautious when reviewing participation rights in bespoke side letters:

1. Pro Rata Based on Converted Ownership

It’s important to ensure that participation rights are tied to the investor’s actual ownership percentage after conversion but immediately prior to the equity financing round. Some investors may attempt to include a fixed participation percentage or use a different formula, which should be avoided. This can result in super pro rata rights, where an investor secures a larger share of the round than their converted ownership would justify. Ensuring the pro rata rights are based on the investor’s converted ownership helps maintain balance by allowing the investor to participate proportionally in the conversion equity round, without granting them undue influence over the allocation of shares.

2. Ongoing Participation Rights Beyond Conversion

Some side letters lack language specifying that participation rights terminate after the round in which the SAFE or note converts into equity. Without a clear termination provision, participation rights can extend into future rounds, providing investors with long-term dilution protection that wasn’t anticipated. However, after the conversion round, SAFE investors should receive the same participation rights given to new investors—nothing more, nothing less. This ensures fairness and prevents the possibility of “double dipping” by granting them rights that exceed those of other preferred shareholders.

Additionally, while many early investors aim to preserve their ownership percentage through the conversion round, they may not really require ongoing participation rights in later rounds. This is often because they lack the capital to participate in later, more expensive rounds, or their investment strategy doesn’t include long-term participation. That said, there are exceptions, and ongoing participation rights may be important to some investors, depending on their financial capacity and strategy.

3. Transferability of Participation Rights

Another key difference from the Y Combinator model can be the absence of a non-assignment clause. Without restrictions on transferring these rights, investors could freely assign their participation rights to third parties, including less favorable or even competitive entities. A non-assignment provision helps protect the company by preventing these rights from falling into unknown hands.

The Takeaway

Participation rights play a critical role in convertible note and SAFE side letters, but the way these rights are structured can have lasting implications. By ensuring that participation rights are based on ownership percentages, terminate after conversion and are non-transferable, companies can strike a balance while protecting their future cap tables.

Have Questions About Your Convertible Note or SAFE Side Letters?

Feel free to reach out to me for further guidance.

Reach Out to Marc Ernaga

• Email: marc.ernaga@momentuslegal.com
• Phone: 650.391.5367
• LinkedIn: @MarcErnaga