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How do you know whether or not to offer an investor pro rata rights, and what is that investor entitled to?
If you’ve been tuning in to our recent series of blog posts mapping the many steps that a startup needs to go through when trying to raise Series A venture capital funding, then you already know that it’s quite a detailed and complex undertaking.
First, there’s the exhaustive preparation and evaluation process to see whether a startup is even ready to raise money or not.
Then there’s the due diligence process during which a VC will perform an audit of your company to determine if you are safe to invest in or acquire.
Even after all of that, the decisions you need to make and the processes you need to perform don’t get any easier as you edge closer to your goal of raising Series A funding.
Another fairly complex concept that comes around the corner in these final phases is the question of pro rata rights.
If you’ve already raised a Seed round, then there’s a good chance that your early investors will want to participate in later rounds as well.
A pro rata right is a right that is given to an investor that allows them to maintain their initial level of ownership percentage during later financing rounds.
With pro rata rights, the investor is not obligated to maintain their percentage of ownership in subsequent rounds, but they have the right to do so if they wish.
Sound confusing? Let’s take a deep dive into what pro rata rights mean for startups and investors to get a better understanding of why they are so important.
How Do Pro Rata Rights Work?
When we talk about pro rata rights, we are talking about the concept of dilution.
Every time your startup raises a new round of funding, new shares are issued and the equity stake of the current shareholders is diluted, meaning that these shareholders (founders and early investors) will lose voting power as members of your board of directors because new shares will have to be distributed to new investors.
The way for an early investor to prevent that is by including a provision that grants them pro rata rights. This will allow them to keep the percentage of their equity stake unchanged and maintain their voting power even when new shares are issued.
In most typical scenarios, early investors are granted pro rata rights.
As stated earlier, even when they are granted pro rata rights, they have no obligation to invest in later rounds in order to maintain their equity share.
To better illustrate the process, here’s an example of what this could look like:
- An investor invests $10,000 into your startup’s Seed round with a $1 million valuation cap. This means that the investor owns 1% of your startup.
- Your startup raises $2 million in its next round of funding.
- If the investor decides against participating in this round of funding, their shares will be diluted and they will own less than 1% of your startup’s shares.
- If the investor chooses to exercise their pro rata rights and finances 1% of the next round, which would cost $20,000, they would maintain their 1% equity stake.
Why Pro Rata Rights Are Important to Investors
Pro rata rights are important to investors because they want to be able to keep their equity in startups that they see are doing well. Remember, not every investment turns out to be a huge success.
Some funded startups will inevitably fail, some might do well enough for VCs to make back the money they invested, and a select few will turn into huge success stories, unicorns even.
Being able to maintain ownership percentages in startups that do undeniably succeed is how venture capitalists make money.
Pro rata rights exist as a reward for early investors who were willing to support the startup at the riskiest stage of investment.
That’s why it’s important for these early investors to avoid having their shares diluted once the startup is on a positive growth trajectory and wants to raise another round of funding.
Pro rata rights can mean the difference between making thousands and millions of dollars on an investment, which is why they matter so much to investors.
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Under What Circumstances Would Investors Waive Their Pro Rata Rights?
As we’ve already stated, investors have the right to claim their pro rata rights, but it’s not obligatory. Obviously, they’ll want to claim their rights if it’s evident that the startup is doing very well and success looks imminent.
However, there are also instances where investors might not claim their pro rata rights. These include:
- A Lack of Money to Invest: Even if the startup is doing well enough that it’s a no-brainer to claim the pro rata rights, some investors might simply not have the money needed to make another substantial investment at the time. This is especially true for small investors, who might not be able to cover the amount needed to retain their shares in subsequent rounds.
- Poor Projections: Sometimes it’s obvious that the startup’s outlook isn’t great. In such a case, it’s usually in the best interest of investors to cut their losses and refrain from investing further capital into that company.
Partial activation of pro rata rights is also an option in some circumstances. But what would that look like?
Imagine an investor has a 10% share in the startup but needs to invest $1 million in order to retain the existing stake over the next round of funding.
If the investor doesn’t have a million to invest at the time, they might want to invest $500,000 and retain 5% of their stake instead of the original 10%.
If the investor believes that the startup has a lot of promise and can potentially be very successful, this could still be a very profitable option.
Are Pro Rata Rights Legally Binding?
Just as investors don’t have an obligation to claim their pro rata rights, startups don’t have an obligation to offer them in the first place.
However, once pro rata rights are offered to an investor, they are legally binding.
What this means is that startups need to think long and hard before offering pro rata rights in order to be as certain as possible that keeping this investor as a core member of the team is in the best interest of the company’s near and distant future.
However, it’s not uncommon for founders to successfully convince investors with pro rata rights that it could be in the best interest of both parties to relinquish these rights.
Usually, the argument is that letting in new investors with better connections and fatter pockets could take the startup to new heights that might not be achievable without involving these new parties.
But in the case of a disagreement in which the investor with pro rata rights refuses to relinquish them, they will usually win any potential litigation that could result, since the pro rata rights are, in fact, legally binding.
How Do Pro Rata Rights Affect Startups?
Taken everything we’ve talked about into consideration, it’s fairly plain to see that pro rata rights serve the investor most. Having and not having pro rata rights can make a huge difference in the investors return on investment.
But what does a startup get from offering pro rata rights? Security? Maybe.
If the startup is unsure about its growth potential, making sure that the original investors stick with them could be a smart maneuver.
However, if the startup is clearly doing very well and looks as if it’s not going to have any problems finding new investors for future rounds, then why even offer pro rata rights to early contributors?
It’s really impossible to give any concrete advice on the matter other than this; be open and communicative with your investors.
The relationship between a founder and investor is a very complex one, one in which it’s best to get used to having difficult discussions and keeping the lines of communication open at all times.
Ultimately, both founders and investors want to do what’s best for the company.
Whether offering pro rata rights or not is what’s best for the company will depend on an almost limitless amount of factors, some of which might even be out of your control.
The best course of action is to have these tough discussions early in hopes of being at least somewhat on the same page regarding the best course of action for your company when the time for discussing pro rata rights comes.
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