Pro Rata Rights: What Startup Founders Need To Know
We always remember the people who believed in us first. Our parents. Our friends. The angel investors and venture capitalists who put their money on the line in a seed funding round.
This last group especially likes to be remembered as your startup continues to grow and attract new investors. And in many cases, a simple “Thank you” card won’t cut it. Early investors often want the option—nay, the right—to maintain their equity stake in a startup that’s growing and doing well. This is where pro rata rights come in.
Before you dust off your old Latin textbook, allow us to explain. Pro rata translates to “in proportion.” So, a pro rata right is an investor’s right to grow their equity stake “in proportion” with the issuance of new equity in later fundraising rounds.
In this guide, we’ll review the basics of pro rata rights and why they matter for investors and early-stage startups. And we’ll try to keep the Latin to a minimum.
- What are pro rata rights?
- How do investors obtain pro rata rights?
- How pro rata rights work: An example
- Why would an investor waive pro rata rights?
- Are startups required to offer pro rata rights to investors?
- Thinking about pro rata rights as a startup founder
What are pro rata rights?
Pro rata rights are rights that entitle existing investors to keep their initial ownership percentage in subsequent rounds of financing. For example: say an investor owns a 5% equity stake in your company before a new round of funding. A pro rata right entitles that investor to a 5% stake of the new shares issued in that funding round.
Pro rata rights typically apply in the subsequent round of funding after they’re granted (they may also apply in later rounds, though not always). This gives an early investor the option to continually invest in a company as the company’s valuation grows. Otherwise, the investor’s initial investment would continue to shrink as a percentage of the overall equity ownership in the company.
Pro rata rights are a big deal in the world of venture capital, as they can mean the difference between a pretty nice and gargantuan return on investment. But it’s also important to remember that investors with pro rata rights are not obligated to use them. They only need to invest in later rounds if they have an interest in maintaining their proportional share of equity, versus seeing it diluted.
What is equity dilution and why does it matter?
Equity dilution is the concept at the heart of pro rata rights. And fortunately, it’s not as complicated as it may seem.
An early-stage startup will likely have a cap table that records the stakeholders (including employees, investors, and founders) along with how many shares they own. Every time new investors come on board in a future financing round, additional shares of equity are issued and those investors/shares are added to the cap table.
But what happens to the existing stakeholders in the company? Well, if they don’t have the option to purchase a percentage of those new shares themselves, their ownership stake will be diluted. In other words, they will continue to own the same number of shares as before, but that number will be a smaller percentage of the overall equity.
This is not always a desirable outcome for early investors! It means they have less exposure to the upside of future growth than they would if they maintained a proportional percentage of ownership. And it could even mean they lose influence or voting power.
How do investors obtain pro rata rights?
Investors typically negotiate for pro rata rights as part of an investment agreement. Angel and seed investors will often include a pro rata clause in their agreement for a number of reasons, including:
- It can ensure that they have the chance to invest in subsequent funding rounds, such as a Series A or a Series B (or a Series C…or a Series D)
- It can ensure they maintain a certain percentage of ownership required for a seat on the board (though this isn’t always applicable)
Pro rata rights are not a foregone conclusion, and there are cases in which they are not granted to early-stage investors. Small investors, for example, may not have the kind of negotiating leverage required to extract pro rata rights from an investment agreement.
Are startups required to offer pro rata rights to investors?
No. There’s nothing that says a startup is required to offer pro rata rights to early investors.
With that said, pro rata rights may come with some benefits for the startup as well as for the investor. For example, granting an investor pro rata rights is a way to potentially fill one seat at the table during the next fundraising round. Now, Investors don’t have to exercise their pro rata rights, so this benefit only applies if the investor is interested in being part of the next fundraising round in the first place. But it does save the time and effort of having to poke around the VC marketplace and pitch to a new investor, which can be a big plus.
Just be aware that the opposite can also be true. Granting pro rata rights to a poorly connected or uncooperative investor could set you for a headache later down the road.
How pro rata rights work: An example
In order to illustrate how pro rata rights work in practice, let’s walk through a hypothetical example with hypothetical numbers.
Let’s say you’re an angel investor in an exciting new A.I. startup. In a seed fundraising round, you invest $200,000 in the startup at a $10 million market cap, which means you now own 2% of the company. As part of the negotiation to secure your initial investment, you are granted pro rata rights in the seed round.
The startup does well for a couple years, and eventually the seed round is followed by a Series A round. In the Series A, the company has a $15 million pre-money valuation, and a $20 million post-money valuation.
At this point—since you were granted pro rata rights in the seed round—you have two options.
Option 1: Exercise your pro rata rights and keep a proportional equity stake
If you exercise your pro rata rights, you will need to invest an additional $400,000 in order to maintain your 2% share of ownership in the company ($400,000 is 2% of the post-money valuation of $20 million).
Option 2: Sit pat and don’t participate in further investment
If you choose not to exercise your pro rata rights—which is totally a choice you can make—you can simply do nothing. This means that you will own 2% ($300,000) of the company at its pre-money valuation of $15 million, but only 1.5% of the company at its post-money valuation of $20 million. You don’t lose money, but your equity is diluted.
Why would an investor waive pro rata rights?
An investor may waive their pro rata rights for any number of reasons. Perhaps they simply don’t have the additional capital to invest. Or perhaps they’re ambivalent about the company’s growth prospects and don’t mind their equity being diluted a bit.
In some cases, the decision isn’t made solely by the investor but in cooperation with the company’s founder or founding team. And it’s important to note that a dilution in equity does not always mean a worse financial outcome, even for investors who truly believe a startup is destined for unicorn status. Relinquishing one’s pro rata rights could allow other powerful investors a seat at the table, thus catapulting the startup to heights that it wouldn’t have otherwise achieved. That’s a good outcome for everyone involved.
Thinking about pro rata rights as a startup founder
We get it. Navigating the murky waters of fundraising may not rank at the top of your list of founder responsibilities. And it’s probably not what you dreamed of when you decided to start a company in the first place.
Still, it’s important to understand how your equity is granted and how it is diluted across your cap table—not only so you know what your investors own, but so you know what you own.
If you want to talk more about pro rata rights and how they may impact your company’s cap table in the future, Pulley is here to help. Schedule a call with us today to learn about our top-rated cap table solution.