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 “in proportion”. Pro-rata rights are given to investors and stipulate that an existing investor will be given the right to participate in at least one future round of funding, proportionate to their existing stake.
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:
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.
Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.
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