The Pro Rata Conversation Can Be Tough (But It Doesn’t Have to Be)
Ask a seasoned venture capitalist about pro rata and they’ll likely give you a response reminiscent of someone talking about air travel: “It’s not what is used to be.” Put simply, pro rata investment rights give investors the ability to re-invest in a company’s future rounds in order to maintain their ownership %.
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.
Pro rata as an investor
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.
Pro rata as a founder
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. On one side of the argument, a founder made an agreement and should respect the pro rata rights and live up to their word.
However, it can be awfully 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.”
So what does this mean?
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.
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.
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.”