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:
See How I Can Help You With Your Fundraising Efforts
- Fundraising Process : get guidance from A to Z.
- Materials : our team creates epic pitch decks and financial models
- Investor Access : connect with the right investors for your business and close them