Pro-Rata rights are one of the most important rights investors in private companies enjoy. Just as is the case with share preferences, their true value is commonly misunderstood, as is their long-term effect on the entrepreneurs who provide them.
Entrepreneurs often don’t know about, or commonly misunderstand the implications of pro rata rights often raise friends & family and Seed rounds without providing this protection to their earliest investors. This can later create tensions among investors who are investing at various stages, and can make participation a living hell for the entrepreneur.
What Are Pro-Rata Rights?
Pro-Rata rights give investors who have already invested in a company the right to continue to invest in the company’s future fund-raising rounds, at a rate that maintains their percentage of ownership in the company. Different from anti-dilution clauses, what this means is if you as an investor have 10% ownership of a company, and you have Pro-Rata rights, then when the company decides to raise a new round of investment, you have the right to invest as much capital as needed to maintain your 10% ownership stake.
If you as the Pro-Rata right holder buy less than enough new equity to maintain your 10% share, your ownership position drops. Let’s say your share drops to 8%, then when the next round of funding occurs, your Pro-Rata rights are now set at 8%.
Who Gets Pro-Rata Rights?
Pro-Rata rights are compulsory and usually non-negotiable for institutional investors. In many cases the requirement to obtain them is enshrined in their own LP agreements. Put simply , they raised capital from their Limited Partners (LP’s) under the agreement that they would obtain Pro-Rata rights in every financing. They can not invest in your company without obtaining these rights.
From the Venture Capitalist’s perspective, Pro-Rata rights are easy to understand: If you invested early in a Facebook, wouldn’t you want to have a first right of refusal on future rounds to guarantee your ownership position?
Should Everyone Have Pro-Rata Rights?
There really are two ways to look at this. First, if everyone has them, then no one can complain. One complaint about “bad-VC’s” is when things get good, they muscle the small shareholders out. This means the “friends and family” of the entrepreneur, and very early stage angels: The people who made it possible for the entrepreneur to get ahead. Of course, not all VC’s are bad, and sometimes the company goes through bad periods where lots of extra capital is invested. As a result, anyone who did not participate got diluted down, or virtually out of the company.
If everyone had Pro-Rata rights, this wouldn’t be an issue. When the capital is needed for the bad times, everyone could choose, or decline to participate. If they declined, then they gave up their right to complain.
As an entrepreneur who has gone through this, I’ve always ensured all the people who invested in my companies had the opportunity to participate in every round. They were generous enough to help early on, and it was only fair to give them the right to make their choice later on.
Do Investors Always Invoke Pro-Rata Rights?
Some do, some don’t, and for a wide variety of reasons. Friends and Family and Seed investors likely will not participate in Series A or later rounds. They likely can’t afford to, and as an entrepreneur, you probably don’t want them to continue participating.
Why Seek New Funders?
Even if your friends and family could continue to finance your company’s growth, it is strategically better to get an outside, institutional investor. We’ll get into the details in a further post, but here are a few thoughts:
- Institutional investors require good corporate governance. A business that takes in money from outside investors has a level or responsibility to those investors enshrined in the financing documents. There is a much higher degree of accountability and structure demanded by institutions. These are good things for growing businesses.
- Institutional investors are greedy. In this case, this is not a bad thing! These investors specialize at two things; a) Investing in the best opportunities at the best rate possible, and b) Extracting the most possible value from their investments. “B” is the most important to you as a shareholder. It means that when the time comes to sell the company, they will help you negotiate & extract the highest possible sale price for your company. (This over-simplifies matters greatly, but it’s a reliable rule of thumb).
- Institutional Investors have deep pockets, and a broad network. If you need more capital, the institutional investor has planned for the eventuality, and set aside capital for follow on financing. As long as you execute, they are prepared to participate. They also will introduce you to future funders. By diversifying your pool of investors, you and they are de-risking your future funding needs.
When Pro-Rata Right Holders Pass
Just like individual investors, some funds are capital constrained. Their maximum limit may be different, but it is still there. So sometimes, they just cannot participate, or only in a more limited fashion.
At a certain point, the return on the new capital invested is not worth it to the investor, relative to their first placement. It’s a curious thought, but if your company becomes too valuable, less people will invest. While some early-stage funds will invest $1MM to own 20% of a company, they will probably not invest a further $1MM if not participating means they still end up with 18% of the company.
This makes sense: If an investor has 20% of your company for $1MM, and you raise another $5MM when your company now has a pre-money valuation of $50 million, the investor has a choice: Put in $5MM to maintain a full 20%, or let someone else put in the $5MM, and drop to 18%.
Bad Deals
Unfortunately, sometimes entrepreneurs make very bad financing deals early on, and when the company becomes successful, the earliest funders, the entrepreneur, and the staff get the short end of the stick. In fact, almost all bad financing deals happen early on. The institutional investor won’t let a bad deal happen on subsequent rounds, because that is not in their interest.
I have encountered a few bad deals. Fortunately, the truly awful ones have been few and far between. One deal in particular sticks out as particularly egregious. I’ll tell the story, but change the details, as the company in question still exists, and there’s no need to embarrass them in particular: they’re not that unique.
Early on, the company developed some interesting technology in their space, and got a local venture capital firm to invest ~$1.5MM for 40% of their company. The investment was via preferred shares, and it was also agreed that a total of 20% of the company, all from the common shares, was to be set aside for an employee share option plan (ESOP). Unfortunately, the entrepreneurs did not do their proper diligence on the deal terms, as they were more excited to “close” than on what all the terms meant. As a result, the VC received a 3X preference, full-participation rights, AND they negotiated a unique pro-rata participation agreement. Their unique participation agreement allowed them to invest $1.5MM in any future round to maintain their stock position holding, no matter how large the next round was.
This created an absurd situation a few years later when the company raised another round of capital. The company had executed on growth phenomenally well. However, like so many other companies that were growing quickly, they had not taken the time to build the technology to scale properly, and now were up against a wall. They desperately needed a new capital infusion to make it possible to afford to hire the people to fix their ‘platform’ and allow them to continue to operate. Without the new capital the platform and the company would collapse.
A new investor who loved the growth story, and could see the market potential. This investor offered $10MM for 40% of the company, with the same rights as the prior investor. The company was forced to recognize that they had created a bad situation, and had an issue to deal with. It was going to be ugly. They needed the money, but they had the first investor’s unique pro-rata rights to deal with. If the first investor invoked their pro-rata rights, the cap table would look like this:
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- First VC 40%
- New VC 40%
- Employees 20%
- Entrepreneurs, friends, family… ~0%
If they didn’t take the money, the company could not continue to operate. What happened? The first VC invoked their pro-rata rights. From their perspective, the entrepreneur had executed, but also been careless not to manage technology development properly. This carelessness / undue haste had placed their entire investment at risk.
As a result of the financing, the founders were diluted out, and one left. The other entrepreneur stayed and was assigned options from the ESOP, just like any other employee would be, and the company continued. Before too long, the founding CEO / entrepreneur was replaced, but still given a title and public facing / community building role.
The community thinks the founding-CEO is a hero: they raised a tremendous amount of capital for their company. The reality is their sloppiness cost the original shareholders (including themselves) the company.
If the entrepreneur had done their homework, the cap table would have looked closer to this:
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- All Investors: 40%
- Employees: 20%
- Entrepreneurs, Friends & Family 40%
Or at worst:
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- New Investors 40%
- First Investors 24%
- Employees 20%
- Entrepreneurs & Friends & Family 16%
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Imagine what happens when the company needs to raise another round, and the new investor has similar pro-rata rights? Or what happens when the company sells, and the investors have a 2x / 3x / 4x preference, and full participation? There will be nothing for the employees from the ESOP.
This example may appear similar to one you’re familiar with. It’s ugly, and unfortunately it happens. And it’s completely avoidable with good advice.
If an entrepreneur doesn’t take the time to understand the consequences of the deal they make, and the deal doesn’t go as planned, they have no one to blame but themselves. We all like to plan for best-case scenarios. Only the wisest plan for worst-case as well! So, sometimes entrepreneurs get ‘screwed,’ but in reality, they screwed themselves…
Smart Entrepreneurs
Smart entrepreneurs learn the full implications of every term in the agreements that govern their company operations.
Take the time to learn, and understand the implications of every clause in every corporate agreement, or you have no one to blame but yourself when things go sideways.