Everything a Startup Founder NEEDS to Know about Pro Rata Rights
Just as the early-stage venture capital landscape has changed over the years, so have the terms and relationships. With the explosion of early-stage investors and the increasing ease of starting a company, pro rata rights have become a point of contention and confusion for founders and investors alike.
As always, we suggest talking to a lawyer when raising capital.
What are Pro rata rights?
To understand how pro rata rights might impact your business, you need to understand what they are. As the team at Holloway writes, “Pro rata rights (or pro rata) in a term sheet or side letter guarantee an investor the opportunity to invest an amount in subsequent funding rounds that maintains their ownership percentage.”
How do Pro rata rights work?
Pro rata rights are negotiated during a venture fundraise. Once pro rata rights are reached (or not) during the negotiation process, they are in place. Remember, this is only the ability to invest at a later date, not a guarantee. Pro rata rights are extremely common in early-stage rounds.
Pro rata rights are a critical tool in handling shareholder dilution. As you’ll see in our example below, when founders go on to raise future rounds, their current shareholders are diluted. Pro rata give certain investors the ability to fight dilution and keep their current % of ownership. On the flipside, this can potentially dilute a founder even further.
Pro Rata Rights Example
Pro rata rights are generally calculated on a percentage basis (example below) but there are rare circumstances where they can be calculated on a dollar basis.
- Investor ABC invested $100,000 at a $1,000,000 valuation (with pro rata rights) into Startup XYZ and owns 10% of the company.
- Startup XYZ is raising a future round at $2,000,000 valuation. Because of dilution, Investor ABC will now own less than 10% of the company.
- If Investor ABC exercises their pro rata rights, they will have the option to buy enough shares to maintain 10% ownership in Startup XYZ.
Why are Pro rata rights important to investors?
Pro rata rights are often seen as a main advantage for early stage venture firms and investors. The ability to follow on and maintain their ownership percentage is vital to the firm’s ability to make an exponential return on their investment.
Investors often have different views about extending their pro rata rights. For example, Point Nine Capital guarantees they’ll invest in any of their portfolio companies’ Series A round. As Christoph Janz, Managing Partner at Point Nine, explains:
- In ~ 80–90% of cases we want to do our pro-rata anyway
- In ~ 5-10% of cases we don’t want to but kind of have to, to prevent harm from the portfolio company due to bad signaling
- Committing to our pro-rata in the remaining ~ 10% might lead to some sub-optimal capital allocation, but this will be far offset by all the other advantages
On the flip side, angel investors or smaller firms may not have the capital to continue to invest and choose waive their rights. However, firms like Point Nine may not have the option to continue to invest, even if they would like to.
According to Fred Wilson, Founder of Union Square Ventures, “In the last ten or so years, companies, lawyers, boards, management teams, founders, and in particular late-stage investors have been disrespecting the pro rata right by asking early-stage VCs to cut back or waive their pro rata rights in later stage financings.”
When a company sets out to raise a later round, the company is likely doing well, so allocations get tighter. The only way for these later firms to get their desired piece of the pie is to ask early-stage investors to hold back from investing.
Understandably, this can be a major point of disappointment and frustration for early-stage firms, as they’ve taken the risk of investing early, which helped make it possible for the company to grow. Ultimately, a pro rata right is a legal obligation and is seen as an agreement a founder is expected to live up to.
When would an investor waive their Pro rata rights?
As we mentioned earlier, there are instances where an investor might waive pro rata rights.
- Lack of Capital — If raising at a later stage or high valuation, some early stage investors with pro rata rights simply might not have enough capital to invest.
- Poor Data — If an investor does not believe in the company or investment ability they might pass.
- Against Thesis — Sometimes a fund has an investment thesis that might keep capital or ownership constrained so they might waive their rights.
Why are Pro rata rights important for startup founders to understand?
On the flip side, a founder may find themselves facing a dilemma where they have new investors ready to invest but need existing investors to waive their pro rata rights.
However, it can be tough for a founder to turn down capital when it is knocking on their door. While not contractual, many early-stage investors promise more than capital, including help, network access, resources, etc. as part of their investment.
So when a later-stage firm is requesting a larger ownership percentage and would need earlier-stage firms to back down, founders must answer this question: did these early investors meet their promise? If the answer is no, it may be easier to waive the pro rata rights and potentially burn a bridge when a particular investor did not live up to their agreement.
If the answer is yes, however, founders will likely have a sense of loyalty and the desire to continue their relationship in future rounds.
When studying Fred Wilson’s post above, Connie Loizos, Founder of StrictlyVC, responds with, “the answer probably isn’t to put more teeth into these agreements… the solution seemingly, based on conversations we’ve had with founders and VCs in the past, is to be a better VC.”
Build meaningful relationships with your investors
Understandably, pro rata can be a tough conversation for both founders and VCs. On one hand, a pro rata right is a legal contract and something investors should expect to be honored when the time comes. While on the other hand, founders are getting pulled in every direction and are obliged to make the right decision for their company.
As Mark Suster puts it, “Make sure you have an open conversation with your early investors about their interest in participating in subsequent rounds as those fund raisings become imminent and that might range from “Are you willing to show some support in the next round, which might be important to incoming investors?” to, “Are you willing to step back a small amount from pro rata to make room for new investors if need be?” Knowing how your investors are thinking is critical as is open communication.”
The simplest way to keep all parties happy? Form a relationship and have the difficult conversations before you’re put in a tough spot under the wire. Founders, don’t be afraid to have open and difficult conversations with your investors. They are invested in what is best for your company as well.
If investors are not aware of a portfolio company raising funds and the potential for a new investor taking a larger percentage, there is clearly something broken in the communication process by both parties. A simple way to up your communication skills? A monthly investor Update.
Founders can leverage monthly investor updates to tap into their investor’s network, capital, and experience to move their business forward. Raise capital, update investors and engage your team from a single platform. Try Visible free for 14 days.