Our Take on Pro-Rata Rights

Whether it is cocktail party talk, boasting in the Twitterverse or just having a quiet happy moment of reflection, investors like to talk or reminisce about the early stage investments they made that “went big”.

These achievements help VC Managers raise new, bigger funds showing LPs their skill in selecting exciting new founders and technologies. On a more spiritual level, these investments become momentous times in someone’s life, things that define legacies and make others proud for many years to come. For these reasons, we seek to maintain or protect this ownership as the company in question grows and raises additional capital at higher valuations. It is here when remembrance or respect evolves into an expectation or even a right to continue to maintain their equity stake in your business. Here, we rummage through the crowded toy box of jargon VCs use and pull out the term “pro rata”.

The literal Latin meaning of “pro rata” is “in proportion”. In the case of startup investing, a pro-rata right is an investor's right to grow their equity position within your business “in proportion” with the issuance of new equity in later fundraising rounds.

The purpose of this blog post is to act as a little resource guide for founders, including pro-rata rights in their capital process. I have seen more than a few instances in the last two years where founders were not as well attuned to what this right means, and it had a pretty negative impact on their business, onto the demystification.

Here is how it all works

Pro rata rights entitle existing investors to preserve their initial ownership percentage of your business in subsequent financing rounds. For example, if VC Fund A invests $500k in your seed round (and you include the provision of pro rata rights in your fundraising documents), buying 5% of your business, they are entitled to a 5% stake of the new shares issued in the next round.

Pro rata rights typically apply to the next round of financing and not always for subsequent rounds after that (that is not always the case, though). This means that as the company grows in scale and, hopefully, valuation, the value of its 5% stake increases exponentially. If they cannot or choose not to exercise their pro rata right, their percentage ownership of the business shrinks or dilutes as more shares are made available.

“You invest $50k in a seed round at a $5mm cap and own 1% of the company. The next round is a $3mm round at $9mm pre, $12mm post. If you don’t participate, you will be diluted by 25% and then own 0.75% of the company. On the other hand, if you buy 1% of the round, a $30k investment, you will continue to own 1% of the company. Your ‘pro-rata right’ in this situation is a $30k allocation in the next round.”

In my usual fashion, I thought I would create a couple of infographics to explain this more visually:

What happens if you don’t want an investor to take up their pro rata rights?

Simply put, it would be hard to get out if you granted pro-rata rights to an investor.

On a cultural level, I have a bit of a problem with the term “Right to exercise” when it comes to pro-rata. Personally, the ability to maintain or even increase your position should be determined by the level you directly help your portfolio company grow. If you are passive and make no attempt to influence the growth of the startup you funded positively, then why should you have this right?

Recently, I have seen the pro-rate right used to brilliant effect, where engaged existing investors continue to invest and support the company in the next round. I have also observed firsthand founders with cap tables of disruptive and entirely passive investors who still demand to exercise their right to preserve their equity stake in a company. I recommend you spend as much time as possible getting to know your investors and discussing what they can offer you before you take investment and likely sign up for pro rata rights.

Most investors want a pro-rata provision in the share purchase agreement, which will probably be a deal breaker if you challenge it. You could include a provision limiting rights to investors who maintain a percentage of ownership within the business. I have seen this to be circa 5%, but it is up to you and the prospective investor. The right to preserve a position is limited to those with meaningful business ownership. 

Ultimately, if you agree to offer pro-rata rights to an investor, you can’t walk it back—it is legally binding.

Why do some investors choose not to exercise their pro rata rights?

Pro rata rights can define the career or the scale of the potential gains from a startup investment that performs exceptionally well. For early-stage VCs, who are often small funds, the dilution on a pre-seed investment that nets them initially 3% can be severe if they do not have the capital to preserve the pro rata. Some funds create SPVs (Special Purpose Vehicles) or specific nominee structures to enable them to continue taking up their pro-rata in individual portfolio companies. These can also be powerful tools to help fund managers raise subsequent funds.

Suppose your startup is performing well, and you have an oversubscribed next round. In that case, some investors (typically those with a significant position) may take the high road and relinquish a certain percentage of their pro-rata allotment. This allows other new investors to join the cap table and hopefully help the startup continue to grow to its potential.

In my time, I have also seen start-ups that accepted something called super-participation rights to their investors. This means that investors who exercise their pro-rata rights can step in for a second helping of the leftover rights that non-participating investors leave on the table. If your next round is oversubscribed or you don’t want your existing investors to increase their position, I hope you do not have super-participation rights in your agreements.

Despite the above scenarios, in my experience, the two most common reasons VCs (and angels) do not take up their pro-rata rights in the later rounds are

• They don’t have the available capital.

• The company is not performing as well as expected, and they do not want to continue to invest.

In my opinion, when an existing investor does not continue honouring their pro-rata rights, without a logical rationale, in the early stages of your business, it is a bit of a red flag in the due diligence process. If this happens to you, make sure you have a clear understanding of why this is happening and if it is because they do not have the funds, then make sure they convey that to any new investors.

How do pro-rata rights affect startups?

As you can probably glean from this post, pro rata rights primarily benefit the investor more than the investee. However, if you are a startup founder, I highly recommend you become thoroughly acquainted with how pro-rata rights work and what they mean for your business.

Some founders look at pro-rata rights as being a form of security. Security in the sense that if you are still finding product market fit, having a bunch of existing investors motivated to continue investing could be a significant lifeline for your business.

Suppose your startup is doing well, and it looks like fundraising will be a walk in the park for your business. Why would you offer pro-rata rights to your earliest investors who might not be exceptionally skilled in the nuances of later-stage investing? On the one hand, we like founders who respect and value the earliest investors who initially worked their butt off to help you. On the other hand, why continue allowing an investor who gave you $50k at your ridiculously low $1m pre-seed round valuation to keep their 5% when your later investors have helped you get to a $250m valuation own less of the business?

This is a complex thing to manage and one that is likely to be full of emotions and ones that may not reflect what is best for your business. As with all situations like this, I find that clear and regular communication is the best remedy. Make sure you have tough conversations early so that you and cap table remain on the same page, hopefully, the best page for the business.

Critical takeaways for Founders:

• Spend time ensuring you know how pro-rata rights work and what it means to you, your team and the wider business.

• Shape and define your pro-rata rights strategy before you raise capital. Play out the lifecycle of your business over the next ten years and decide what type of investors you want to receive pro-rata rights.

• Keep track of your investor's pro-rata rights positions and communicate with them regularly.

• Have contingency plans for when existing investors may not take up their pro-rata rights. Make sure you have a good reason why they are not participating again.

• Make sure you use a reputable and experienced lawyer when structuring or considering pro-rata rights. A couple of thousand bucks could save you millions in the future.

Most pro-rata participation rights are written in a way that they become quite onerous to implement. You may have to send out heaps of certified letters, arrange group webinars with investors, deal with flaky or non-responsive investors, gather lots of signatures and sometimes do mathematically impossible things! So even if you honour the pro-rata rights, you will probably have to include some waivers and jiggery-pokery. I suggest you honour the rights to make life easy for you, especially in the first round. This is the deal you struck with your investors, and I recommend not contesting it. Equally, be extremely cautious around new investors who want you to disregard your early investors without a sound reason, especially those who have played an active, positive role in the business.

I would like to see pro-rata rights provisions evolve to more of a merit-based approach, however until this time, keep a cool head, plan eight steps ahead and communicate as much as you can.

Best of luck!