The “Shadow Round”: How Insider Side Letters and Hidden Terms Quietly Reprice Your Startup (and How to Defend Yourself)

Most founders think fundraising happens in rounds: Seed, Series A, Series B. One price, one set of documents, one cap table.

In reality, many startups run a second, quieter financing in parallel—a set of insider agreements that change the economics and control of future rounds without changing the headline valuation today. This is the shadow round.

The shadow round isn’t always malicious. Sometimes it’s an investor trying to manage risk. Sometimes it’s an accommodation a founder makes to “get the deal done.” But the effect can be the same: your next round becomes more expensive, more constrained, and more fragile—and the repricing shows up exactly when you can least afford it.

This article explains four common “shadow” mechanisms—MFN clauses, pro‑rata traps, ratchets, and side letters/hidden terms—and how to negotiate against them with tactics that are realistic in the venture market.

> Important note: This is not legal advice. Treat it as a technical map of the terrain so you can ask better questions of counsel and run a cleaner process.

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1) What the “shadow round” really is (and why it works)

A startup’s headline valuation is a story: “We raised $X at $Y pre-money.” That story is useful, but it’s incomplete.

Your effective pricing and control are determined by:

Economic preferences (liquidation preference, participation, dividends)

Anti-dilution and repricing rights (weighted-average, full ratchet, etc.)

Allocation rights (pro‑rata, super pro‑rata)

Future round constraints (consent rights, pay‑to‑play, vetoes)

Information and side agreements (side letters, board observer rights, special approvals)

These are often negotiated outside the headline term sheet in:

Side letters (sometimes confidential)

Investor rights agreements with asymmetric amendments

“Special rights” buried in stock purchase agreements

n- Notes/SAFEs with MFNs that trigger later

The mechanism works because it exploits two asymmetries:

Disclosure asymmetry: not all investors see the same deal.

Time asymmetry: you don’t feel the pain until the next round.

When you do feel it, the company may be weaker (cash pressure, missed metrics, market downturn), and insiders have leverage.

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2) MFN clauses: the “quiet repricer” that upgrades investors later

What an MFN is

MFN (Most Favored Nation) clauses are common in early-stage financings—especially in notes and SAFEs—and occasionally appear in priced rounds via side letters.

An MFN generally says: if the company later issues securities (or agrees to terms) that are more favorable than what this investor received, then this investor gets upgraded to those better terms.

MFN can be:

Term-based MFN: upgrades key terms (discount, valuation cap, liquidity preference, info rights)

Security-based MFN: converts into the “most favorable” security issued later

Broad vs narrow: applies to “any investor” or only to “similarly situated” investors

Automatic vs elective: investor can choose whether to upgrade

Why MFNs can reprice your startup

MFNs usually don’t change today’s valuation. They change the distribution of tomorrow’s economics.

Common repricing patterns:

You give one late SAFE a lower cap to close the round. An earlier SAFE with MFN “upgrades” to that cap—so the entire SAFE stack becomes cheaper than you modeled.

You offer a strategic investor a special information right or side letter. MFN holders claim it too, expanding the set of parties who can delay the next financing with objections or diligence demands.

MFN can also reduce your ability to do targeted bridge financings. The board may approve a small bridge on investor-friendly terms to avoid a down round, but MFN can cause it to retroactively spill across earlier instruments.

When MFNs are defensible (investor perspective)

Investors argue MFN is a fairness mechanism: early check writers shouldn’t be punished if later investors negotiate better.

That’s not totally unreasonable, particularly when:

A round is being formed over time (rolling close)

Investors lack negotiating power individually

The company is improvising terms as it learns the market

But “fairness” becomes optionality when MFN is broad, perpetual, and applies to any side deal.

How to defend: MFN negotiation tactics

Tactic A — Narrow the trigger

Ask that MFN applies only to:

Same security type (e.g., SAFE-to-SAFE only)

Same closing window (e.g., within 30–60 days)

Same investor class (e.g., non-strategic, non-lead)

Tactic B — Exclude specific terms

Carve out from MFN:

Information rights

Board rights/observer rights

Future participation rights

Any governance rights

Any rights granted for regulatory/strategic reasons

You can phrase it as “economics-only MFN,” with a defined list.

Tactic C — Make it elective, not automatic

If MFN is unavoidable, prefer investor election with notice, and require an election within a short time window.

Tactic D — Sunset the MFN

MFN should expire at the next priced round (or a date).

Tactic E — Don’t MFN side letters

Make clear MFN references “terms of the instrument,” not separate agreements.

> Reference points: MFN provisions are common in Y Combinator-era SAFE usage and many note templates; specific drafting varies widely, so your defense is usually about scope, carve-outs, and timeboxing rather than eliminating the concept entirely.

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3) Pro‑rata rights: from normal protection to “pro‑rata trap”

Pro‑rata basics

A standard venture term is pro‑rata participation: the right to buy enough shares in future financings to maintain ownership percentage.

In moderation, this is normal. It aligns incentives and rewards early risk-taking.

The pro‑rata trap: how it harms future rounds

A pro‑rata trap happens when pro‑rata rights become large, inflexible, and senior to your ability to bring in new money.

There are a few ways this shows up:

Over-allocation: too much of the next round is pre-reserved for insiders, leaving little room for a new lead.

Super pro‑rata: an investor can buy more than their pro‑rata—effectively letting them increase control cheaply.

Pay-to-play coercion: an insider signals they’ll block a round (via consent rights) unless they receive allocation.

Allocation conditioning: new investors demand room; insiders refuse to waive; the round becomes structurally impossible.

The repricing angle: if a company must “make room” for new money, it may be forced into:

a larger round than desired (more dilution)

a higher liquidation preference stack (to attract new capital)

a structured deal with participating preferred or ratchets

In other words: pro‑rata rigidity can push you into worse economics.

When strong pro‑rata is reasonable (investor perspective)

Institutional investors (especially leads) often need pro‑rata to:

defend ownership targets required by fund economics

justify time/board involvement

avoid being diluted out of upside by later, larger funds

For a true lead who brings signal, recruiting, and follow-on capacity, meaningful pro‑rata can be the price of partnership.

But the trap usually comes from many small investors holding strong rights, or from pro‑rata being coupled with hidden vetoes.

How to defend: pro‑rata tactics

Tactic A — Define a clean “Major Investor” threshold

Pro‑rata should be limited to investors above a meaningful threshold (e.g., $250k/$500k/$1M depending on stage). This reduces administrative and structural burden.

Tactic B — Cap the total pro‑rata pool

Explicitly reserve a percentage of the next round for new investors and employee option refresh. Put it in the term sheet as an expectation.

Tactic C — Board-managed allocation, not contractual entitlement (where possible)

In some early rounds, you can shift from hard rights to “good faith opportunity” language.

Tactic D — No super pro‑rata without a price

If an investor wants super pro‑rata, treat it as a distinct concession: either a lower valuation (explicit), or a governance give (explicit), but don’t give it away silently.

Tactic E — Waiver mechanics

Make waivers practical: specify that the company can reallocate unused pro‑rata after a deadline, with no holdouts.

> Reference points: Pro‑rata rights are typically captured in an Investor Rights Agreement (IRA) in NVCA-style document sets; pay attention to thresholds, definitions of “Qualified Financing,” and allocation procedures.

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4) Ratchets and anti-dilution: the visible landmine and the hidden one

Anti-dilution in a nutshell

Anti-dilution provisions protect preferred shareholders if you later issue shares at a lower price (a “down round”). The two classic types:

Broad-based weighted average: common and generally considered market in priced rounds; softens dilution but doesn’t fully reset price.

Full ratchet: resets the earlier conversion price to the new, lower price—much more punitive to founders and employees.

Ratchets can also appear as:

milestone-based “earn back” shares

warrant coverage triggered by down rounds

variable conversion features in notes

How ratchets create a shadow repricing

Even when the company avoids a down round, ratchets can affect behavior:

New investors may demand a lower price because they know a ratchet will reallocate equity anyway, making the cap table unpredictable.

Insiders may become less supportive of “flat” financings because they benefit more from a down round if they have strong anti-dilution.

More subtly: ratchets can sit in side letters or in bespoke preferred terms granted to a single investor, creating asymmetric conversion economics.

The result is a company that looks fairly priced on the surface, but is over-encumbered underneath.

When anti-dilution protection is reasonable (investor perspective)

Weighted-average anti-dilution is widely accepted because it protects investors from the worst-case scenario without making the founder’s equity purely optional.

Full ratchet is typically justified only when:

the company is distressed

the investor is providing a rescue round

the investor has no other way to price risk

Even then, it’s a sign your next round will be hard.

How to defend: ratchet/anti-dilution tactics

Tactic A — Prefer broad-based weighted average (and understand the “broad-based” part)

Broad-based means the denominator includes most shares (including the option pool), making the adjustment milder.

Tactic B — Carve out legitimate issuances

Ensure anti-dilution excludes:

option grants under an approved plan

shares issued in acquisitions

strategic issuances approved by the board

Tactic C — Avoid “shadow ratchets” via side agreements

Watch for warrants, price protection, or hidden conversion adjustments granted in side letters.

Tactic D — If a ratchet exists, timebox and condition it

If you must accept something ratchet-like:

make it expire after a short window

tie it to a specific financing type

require board approval including common directors

> Reference points: NVCA model docs cover standard anti-dilution; “full ratchet” is generally considered off-market for healthy venture financings but appears in structured or distressed deals.

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5) Side letters and hidden terms: the governance and control shadow

What side letters are

A side letter is a separate agreement between the company and an investor that grants rights not shared by the full class.

Side letters are not inherently bad. They can address:

regulatory constraints (e.g., an institutional LP’s reporting requirements)

confidentiality requirements

specific information rights

observer rights

The problem is when side letters grant rights that:

change economic outcomes for one investor (creating a de facto different deal)

create hidden vetoes or approvals

impose operational constraints that make future rounds harder

Common “hidden terms” that bite later

Enhanced information rights

- monthly financial packages
- budget approval expectations
- customer pipeline disclosure

These can raise diligence burdens and leak-sensitive data.

Board observer rights with teeth

- observer can attend all meetings, receive all materials
- observer consent required for certain actions (that’s not an observer; that’s a shadow director)

Consent rights buried outside the charter

- veto on future financings, option pool increases, debt
- veto on hiring/firing execs

Favored liquidity or exit rights

- redemption rights with aggressive timelines
- registration rights beyond standard

Transfer rights and secondary approvals

- investor can sell but company cannot manage buyer quality

Most-favored side letter (side-letter MFN)

- if any other investor gets a side letter, this investor gets it too

That last one is how side letters metastasize.

Why side letters quietly reprice valuation

Valuation isn’t just price per share; it’s also freedom of action.

A company with:

multiple veto holders

heavy reporting requirements

complicated investor coordination

uncertain cap table outcomes

…will often be priced lower, because the next lead knows execution risk is higher. The “shadow” terms convert into a real discount at the worst time.

How to defend: side letter tactics

Tactic A — Adopt a “side letter policy” early

Decide (and communicate) what is allowed:

Allowed: limited information rights, regulatory disclosures

Not allowed: economics changes, vetoes, conversion tweaks, secret preferences

Tactic B — Require disclosure to the board and counsel

Founders sometimes accept side letters directly. Don’t. Route through counsel and ensure the board is aware.

Tactic C — Standardize via an IRA schedule

If an investor needs special reporting, put it in a standardized schedule with clear limits, rather than bespoke language.

Tactic D — No side-letter MFNs

If an investor asks for MFN on side letters, resist hard. If you must, narrow it to a defined list (e.g., information rights only), timebox it, and exclude governance.

Tactic E — Define confidentiality and use restrictions

If you grant enhanced info rights, include:

strict confidentiality

no trading/secondary use

limited internal sharing

deletion/destruction requirements

> Reference points: Side letters are widely used in venture but are not standardized like NVCA docs. Their risk comes from being non-uniform and sometimes not fully socialized to all stakeholders.

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6) The compounding effect: how hidden terms interact

The shadow round becomes truly dangerous when terms stack:

A broad MFN upgrades earlier SAFEs to a later sweetheart cap.

Many small investors have hard pro‑rata rights.

One investor has a side-letter veto over new debt.

Another has a ratchet-like warrant triggered by a down round.

Now imagine you’re 8 weeks from running out of cash. The new lead asks for clean governance, room in the round, and a predictable cap table.

Instead, you have:

uncertain conversion math

multiple parties entitled to allocation

hidden approvals required

At that point, the negotiation isn’t about valuation; it’s about whether the round can close at all. If it does, it often closes with:

heavier liquidation preferences

bigger option pool top-up (founder dilution)

structured terms (participation, seniority)

The shadow round becomes the visible round.

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7) Defensive fundraising: process is your first line of defense

Many founders treat fundraising like a sales process. It is—but it’s also a configuration management problem. You’re managing versions of rights across stakeholders.

Here are practical process moves that prevent shadow terms from taking root.

A. Run a “one paper” policy as much as possible

Aim for:

one term sheet

one set of financing documents

minimal side letters

If you must do side letters, keep them:

narrow

timeboxed

disclosed to counsel and board

B. Keep a living “rights register”

Maintain a table (founder + counsel) listing:

investor

instrument

pro‑rata amount

MFN scope

any veto/consent rights

info rights / observer rights

anti-dilution features

This is unglamorous—and it prevents disasters.

C. Model dilution under adverse scenarios

Don’t just model the “up round.” Model:

flat round

small down round

inside-led bridge

Include MFN triggers and anti-dilution mechanics. If you can’t model it, you don’t understand the deal.

D. Control closing mechanics

Rolling closes create MFN pressure and fairness arguments. If possible:

set a defined close date

align major terms early

avoid changing caps/discounts midstream

E. Align the board on “no hidden economics”

You want a board-level norm: if it changes economics or control, it must be in the main documents.

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8) Negotiation playbook: phrases and positions that work

Founders often lose these fights because they argue morality (“that’s unfair”). A better approach is to argue future fundability.

Here are positions that are harder to dismiss.

“We need clean terms for the next lead.”

This frames your pushback as protecting everyone’s upside, including insiders.

“We can offer protection, but we have to cap it.”

You’re not rejecting risk management; you’re bounding it.

“We’ll grant economics parity, not governance parity.”

A reasonable compromise: if an investor worries about price, discuss price protection; don’t let it become veto rights.

“We’ll do information rights via a standard schedule.”

Signals maturity and reduces bespoke drafting.

“Side letters must be disclosed to the company and counsel.”

Non-negotiable. Confidential to other investors is one thing; hidden from the company is unacceptable.

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9) If you already have shadow terms: triage and cleanup

Sometimes you discover the shadow round too late—during Series A diligence, or when a new lead asks for all side letters.

Here’s how to approach cleanup pragmatically.

Step 1: Inventory everything

all SAFEs/notes

all amendments

all side letters

all board consents

any emails that might be construed as side agreements

Step 2: Identify “blocking rights” first

Focus on:

vetoes over financing

redemption rights

unusual protective provisions

broad MFNs

These are the terms that can kill a round.

Step 3: Trade upgrades for simplification

Sometimes you can offer:

small additional allocation

slightly improved information package

a defined waiver fee

…in exchange for removing broad MFN or veto rights. You’re buying back optionality.

Step 4: Use the new lead as leverage (carefully)

A credible Series A lead can say: “We won’t invest unless these terms are cleaned.”

That’s leverage, but it can also create friction. Use it to align insiders around the truth: a messy cap table is everyone’s problem.

Step 5: Document the cleanup cleanly

Do not “handshake” your way out. Amend documents properly, with counsel, and ensure the cap table and rights register match.

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10) A balanced take: investors aren’t villains, but incentives matter

It’s tempting to treat shadow terms as predatory. Sometimes they are. Often they’re just incentives playing out:

Investors want downside protection.

Founders want runway.

Everyone wants optionality.

The problem is asymmetry. Insiders have more information, more time, and more ability to structure.

A healthy venture ecosystem depends on repeatable financings. Terms that quietly reprice the company later are not “clever”; they’re fragile engineering. They increase the probability of a failed raise—which is the worst outcome for everyone.

The standard you should hold is simple:

> If a term changes future economics or control, it should be explicit, bounded, and modelable.

That’s not founder-friendly ideology. It’s basic systems design.

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Practical checklist (use this before you sign)

MFN

[ ] Is MFN limited to the same security type?

[ ] Is it timeboxed (e.g., expires at priced round)?

[ ] Does it exclude side letters and governance rights?

[ ] Is it elective with a short election window?

Pro‑rata

[ ] Is there a “Major Investor” threshold?

[ ] Are allocations subject to deadlines and reallocation?

[ ] Is super pro‑rata excluded or explicitly priced?

[ ] Is there room reserved for new lead + option pool?

Anti-dilution / Ratchets

[ ] Is it broad-based weighted average (not full ratchet)?

[ ] Are standard carve-outs included (options, M&A, strategic issuances)?

[ ] Are there warrants/side adjustments that mimic ratchets?

Side letters

[ ] Do side letters exclude economics and vetoes?

[ ] Are they disclosed to counsel and board?

[ ] Is there a no side-letter MFN rule (or narrow list)?

[ ] Are confidentiality and use restrictions tight?

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References and further reading

NVCA Model Legal Documents (standard U.S. venture financing terms and drafting reference): https://nvca.org/model-legal-documents/

Y Combinator SAFE documents (commonly used early-stage instruments; MFN variants exist across templates and market practice): https://www.ycombinator.com/documents

Fenwick & West / Cooley / Wilson Sonsini publications (law firm guidance on venture terms, side letters, and financing structures; useful for market context and drafting considerations):

- Cooley GO resources: https://www.cooleygo.com/
- Fenwick venture capital resources: https://www.fenwick.com/insights
- Wilson Sonsini entrepreneur resources: https://www.wsgr.com/en/insights

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Closing view

The shadow round exists because it’s easy to agree to terms that feel small today and become large tomorrow. The defense is not paranoia; it’s discipline:

standardize

disclose

cap and sunset optionality

keep governance clean

Do that, and your next round is more likely to be a normal round—not a forced reckoning with hidden math.