Pro-rata rights are given to investors and describe investment rights during future fundraising rounds. Because they impact how founders can later raise capital, it’s critical that entrepreneurs and investors both understand how pro-rata rights work.
In this article, I’m going to explore exactly what pro-rata rights are, how they work, and what entrepreneurs and investors need to know in order to get the most out of them.
What Are Pro-Rata Rights?
“Pro-rata” is a Latin phrase meaning
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This allows investors to invest more startup capital in existing businesses so that their percentage share of the business remains the same.
If an investor doesn’t have access to pro-rata rights, their share of the business could be diluted in later investment rounds as new investors come in. It is, in essence, a way to protect the investor, but this comes at a cost for entrepreneurs as it limits the amount of their business they can offer to future investors.
Why Pro-Rata Rights Matter to Investors
A pro-rata agreement allows an investor to maintain a level of ownership in a company. From the investor’s perspective, they supply the initial capital that allows a business to prosper. When that company reaches subsequent funding round, the existing investor usually wants to benefit from that by investing more money to stop their share of the business diluting.
Let’s take an example; a hypothetical version of Google’s rise to ascendancy (though the real story of how investors made money from Google is fascinating). You invest capital into a small startup company called Google.
For that capital, you are awarded a 10% share in the business. As the business progresses, it becomes clear that Google is going to be a multibillion-dollar business. In order to reach its potential, Google looks for new investments.
If new investors invest, your 10% share may be diluted. Suddenly, you own 1% of a billion-dollar business rather than 10%.
Pro-rata rights protect investors who go out on a limb to support younger businesses. By activating a pro-rata right, when the company becomes a success and looks for further investment, the investor can maintain that 10% by supplying more capital at whatever the new equity valuation is.
In essence, pro-rata rights can be the difference between making a few hundred thousand dollars on investment and making millions of dollars. This is why pro-rata rights matter to investors.
Do Investors Always Activate Their Pro-Rata Rights?
No, they do not. There are several reasons why an investor might not want to claim their pro-rata rights when a new funding round opens up. These include:
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1) Poor Outlook
If a business has a poor outlook, then an existing investor may feel the company is a lost cause and not wish to risk any more of their capital.
2) Lack of Funds
It’s all well and good if pro-rata rights guarantee the option to invest more capital to maintain a share of a company, but not every investor has that type of money at their disposal. Increasing investment in subsequent rounds can require significant resources. This is especially true for small investors. That’s why it’s a great idea to find the ideal angel investor who can scale up their investment later if your company needs it.
3) New Investor Parity
A key part of how pro-rata rights work, is that the amount required to activate them is dependent on the overall amount raised during a subsequent funding round. An investor could invest $50k in a company for a 20% stake during the seed stage. They then get ready to up their investment during Series A fundraising, only for that round to raise $2million. Suddenly, the amount required for 20% of the business is $400k! Some investors will be unable or unwilling to match the new investor parity.
4) Partial Activation
Some pro-rata rights agreements allow investors to put in what they want up to the threshold of the new price for their existing stake. In the previous example, the $50k investor might not want to put up $400K to maintain their 20%, but they might believe they can make a better profit in the long run by investing $100k to keep 5%.
5) Low Investment Strategy
Every investor runs their own portfolio of investments differently. Some prefer to keep a low stake in many companies rather than high stakes in one or two. This strategy can result in such an investor waving their pro-rata rights.
Can Pro-Rata Rights Always be Enforced?
When it comes down to how pro-rata rights work it is important to remember that usually, pro-rata rights are legally binding. This is difficult for entrepreneurs if they made a bad call on an investor during early funding rounds. It’s something that can come back to haunt them, so they should be certain that pro-rata rights are a good idea.
However, as pointed out by venture capitalist Fred Wilson, there has been a growing trend in the number of founders not honoring pro-rata rights when the next investment round opens up.
Founders, directors, and management teams have been successful in some cases in avoiding pro-rata rights activation. However, legally, the pro-rata rights holder still has the upper hand. In some instances, this disagreement can result in litigation.
When investors do agree to relinquish their pro-rata rights, it’s because the founders of the company persuade them that it would be better to let a new investor into the company. This new investor will have connections and financial might to take the business to its next level.
This, founders argue, benefits everyone because it will make equity in the company more valuable. According to Fred Wilson and many other VCs, however, this is happening too often, with some founders simply looking for an excuse to stop an older investor from buying more equity in the business when there are other more lucrative offers out there.
Remember that storytelling plays a key role in fundraising and you will need capital to scale things up. This is being able to capture the essence of the business in 15 to 20 slides. For a winning deck, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.
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Furthermore, you may be interested in the video below how pro-rata rights work where I cover this topic in detail.
FULL TRANSCRIPTION OF THE VIDEO:
Hello, everyone. This is Alejandro Cremades, and today we’re going to be talking about how pro-rata rights work. The pro-rata rights are a very important piece of information that you’re going to find on any offering document when you’re looking at raising a round of financing. Today, we’re really going to be breaking it down for you so that you really understand inside and out what the pro-rata rights essentially are and how it could impact the way that you can raise money today or the way that you’re thinking about raising money into the future, and also, how investors use them to maintain that equity ownership. With that being said, let’s get into it.
Pro-rata comes from the Latin word “in proportion.” What this means is that whenever the investor makes an investment, and you agree to that pro-rata right with them, in a future financing round, they will be able to execute that pro-rata right, which allows them to maintain their equity ownership when new investors are coming.
So, essentially, in every round of financing, you’re going to have new investors, you’re going to be issuing new shares, and that is going to dilute the position of every existing investor in the business. Hopefully, the valuation of the business is much bigger, but it dilutes the position and the ownership of everyone.
With that pro-rata right, that investor gets the opportunity to execute the pro-rata right so that they can continue investing in the business as the business matures and goes from financing cycle to financing cycle so that they can continue to maintain their equity ownership in the business.
In terms of asking the question, do investors always activate their pro-rata rights? The answer is: no. There are going to be multiple factors that are going to determine whether that investor wants to continue reinvesting in the business or not. Some of those factors are the following.
- Poor outlook
- Lack of funds
- New investor priority
- Partial activation
- Low investment strategy
This is going to determine whether they want to go forward or not, but those are negative factors that are going to keep them away from executing that pro-rata right.
Remember, when an investor doesn’t execute their pro-rata right, it could send negative signals to the market because then other investors that are looking at putting money in your business are going to be like, “Hold on a second. This investor is an existing investor. They have the money to be able to reinvest. They’re not doing so. They’re not executing on their pro-rata right, so there’s possibly something wrong with this business.”
That’s why you always want to be careful with this because not executing that pro-rata right from one of your existing investors could put you literally in a very tough situation and perhaps even make your company go out of business if it runs out of money. Be very careful with those pro-rata rights.
Can the pro-rata rights always be enforced? The question is really, yes, from a legal perspective, but no, from a practicality perspective because, in many instances, the founders actually persuade the investor from executing that pro-rata right because maybe there could be greater scenarios like a great investor coming in where they want to take a really big chunk of the business, and by the execution of that pro-rata right is not allowing for that investor to come in.
You’ve seen great examples like Fred Wilson from Union Square Ventures. He’s written several posts on this regard. And you’re going to see founders that are having those tough conversations with investors to help them understand why it doesn’t make sense for them to execute their pro-rata right.
Obviously, it’s important to differentiate when there’s a potential positive outcome from not executing such pro-rata rights from a negative outcome. And that is whether there is already an existing investor lining up or not to make that investment and to give you that money. That is going to determine whether or not it makes sense to go forward with the execution of the pro-rata right.
But, here’s the thing. Always, always, always, you want to keep investors motivated. You want to give them the chance to maintain the ownership if they want, and even though you may have to experience a further dilution, in my modest opinion, and you need to obviously confirm this with your legal counsel, with your corporate lawyer, you want to make sure that the investor, in the long run, is happy with the way that you’re conducting business, with the way that you’re honoring the relationship with you, with the business, and the fact that they invested in your early, that they took that risk before all these people that are coming in now, while you are being successful.
With that being said, I’d love to hear on the comment section below what has been your experience so far with pro-rata rights. Also, Like the video and subscribe to the channel so that you don’t miss out on all the great videos that we’re launching every week.
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