Understanding Pro Rata Rights Is Essential for Investors
Pro rata rights represent the right for investors to participate in subsequent rounds of startup funding beyond their original investment. Pro rata rights are typically used to preserve equity or ownership stakes in a startup in the face of dilution, such as from additional rounds of funding. In this blog, learn more about pro rata rights, how pro rata rights are used, and key considerations for private market investors.
What Are Pro Rata Rights?
Derived from the Latin word for “proportionately,” pro rata rights provide the right, but not the obligation, to participate in a startup’s subsequent funding rounds. Generally included in the term sheet for the original investment, the main purpose of these rights is for investors to be able to maintain their original ownership percentage in the company.
As startups issue new equity shares to investors in future funding rounds, equity dilution can occur and the ownership percentage of all previous investors may decrease. These rights provide a pathway to help mitigate against equity dilution, although with the requirement of an additional financial commitment.
Why Are Pro Rata Rights Important?
For investors, pro rata rights can be an important part of a term sheet, especially for portfolio management. The following are some of the benefits of pro rata rights.
Ownership Preservation
As mentioned already, one of the benefits of pro rata rights is helping to mitigate against dilution, preserving an investor’s ownership stake. If an investor feels validated in their original investment and wants to continue maintaining their ownership percentage through future funding rounds, these rights can help them do that.
Future Access
Pro rata rights can also serve as a tool for accessing future investment rounds. If an investor decides they want to maintain or even increase their ownership stake in a portfolio company, these rights can help them do that. In a competitive funding environment, gaining an allocation in a popular company’s later funding rounds can be challenging. These rights allow for the opportunity to access that funding round for the investor.
Influence and Control
While not in every case, certain investor rights, such as board seats or specific voting powers, may be contingent on maintaining a minimum ownership threshold. These rights can help investors maintain the ownership threshold needed for specific voting rights or board seats.
How Pro Rata Rights Work
When a startup initiates a new funding round, it is legally obligated to notify investors who hold pro rata rights. These investors are then presented with the opportunity to invest additional capital in the new funding round. The amount that they are able to invest is calculated precisely to maintain their pre-existing ownership percentage.
Determining Pro Rata Allocation
Determining how much an investor needs to invest in the next round to maintain their pro rata stake is fairly straightforward:
$ Needed to Maintain Pro Rata Stake = % Stake to be Maintained X # of New Shares Issued X Share Price at New Round
For more a more hands-on approach, consider this example:
Imagine that investor has committed $30,000 to a company in a Seed round with a $3 million valuation, effectively giving the investor 1% ownership in the company. The next round of funding is a $2 million round with an $8 million pre-money valuation and a $10 million post-money valuation.
If the investor chooses not to participate in round two, they will be diluted, and their percentage of ownership will drop below 1%. If the investor does participate in round two, investing in 1% of the round ($20,000), they will maintain their 1% ownership of the company. That $20,000 allocation is the investor’s “pro rata right” for that round.
Final Thoughts
Pro rata rights can provide a structured approach for investors to help mitigate against equity dilution and potentially maintain influence. For companies, managing pro rata rights can help maintain trust and foster long-term relationships.
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Want to learn more about investing in startups? Check out the following MicroVentures blogs to learn more:
- How to Evaluate a Founding Team
- Checklist for VC Due Diligence
- Early-Stage Investing: SAFEs Explained
- Assessing a Startup’s Defensibility
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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.
