We’ve discussed term sheets a lot in the past, particularly from the perspective of founders. This week, the term we’re exploring is very important on both sides of the table but is of particular interest to investors: pro rata rights.
What are Pro Rata Rights?
“Pro rata” is a Latin term that translates to “proportionately.” In the VC world, a pro rata clause is an investment term that gives investors the right to participate in subsequent rounds of funding. This allows investors to maintain their percentage of ownership in a company, and pro-rata rights become especially important as the company grows. Pro rata rights are also sometimes referred to as “participation,” “preemptive”, or “right of first offer/refusal” rights.
Pro rata rights aren’t always granted and are usually only given to larger investors or institutional investors who invest at an early stage. Investors who have pro rata rights are not obligated to invest in future rounds and may use it at their discretion. If a company does not perform well, investors may not use their pro rata rights.
Why Pro Rata Rights Matter
Oftentimes, pro rata rights are a non-negotiable term for institutional investors. This is for a couple of reasons:
- Dilution prevention
- Risk management
With every new round of financing, new shares are issued. When this happens, the percentage of equity stake of current investors becomes diluted. By investing in follow-on rounds, investors are able to avoid being diluted as the company grows.
Institutional investors also use pro rata rights as a way to manage investment risk. For investments that have performed well, institutional investors want to be able to make follow-on investments.
Equity Dilution in Startups
How Pro Rata Rights Affect Startups
While investors are not obligated to utilize their pro rata rights, for companies who are performing well, pro rata rights may incentivize early-investors to keep investing in subsequent rounds as the company continues to grow. The obvious upside being there’s less uncertainty about who will invest in the next round. A potential pitfall would be that should an investor choose not to exercise their pro rata rights, it could signal trouble to potential investors.
Another thing startups should be cautious of is the granting of “super” pro rata rights. Some investors may request pro rata rights that provide them with some percentage beyond their pro rata share. For example, an investor that owns 25% equity following a Series Seed round might request to purchase as much as 50% in the Series A round. This can make it difficult to attract new investors because there might not be enough left to entice them.
Determining Pro Rata Allocation
Determining how much an investor needs to invest in the next round to maintain their pro rata stake is fairly straight-forward:
$ 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.
Understanding Terms: Liquidation Preference
Benefits of Investing in an LLC
As mentioned, pro rata rights are typically only extended to large and institutional investors, meaning smaller investors miss out on the benefits. When investors invest through MicroVentures, they’re not investing directly in a private company; rather, they’re investing in an LLC that invests on their behalf. More simply put, we pool many smaller investments to make one large investment. In the event that pro rata rights are extended to an investment vehicle offering on MicroVentures’ platform, there may be circumstances in which those rights can be passed along to those who invest in that vehicle.
Pro rata rights are one of the most important terms in VC deals. While super pro rata rights may have a bad rap, when managed responsibly, pro rata rights can be a benefit to both the investor and the company.
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.