Pro Rata Rights
Pro rata rights are the rights given by a company to early investors to allow them to invest more and maintain their current equity in the startup through further investment if they choose. This article will cover the definition, purpose, mechanics, and how pro rata rights work in funding rounds.
What are Pro Rata Rights?
Pro rata means proportionate share, so pro rata rights exist to respect, value, and reward the strategic significance of early investors to startup growth.
These rights allow the early VCs or angel investors to participate in later funding rounds, which prevents them from losing their ownership percentage when companies gain more success and higher valuations, which attract more investors.
Without these rights, early investors might invest $1M dollars for a 5% share of a company and then later, at the Series A or Series B stage, the startup might quickly grow, and if the early investor is no longer able to participate.
Purpose and Investor Benefits
The strength of pro rata rights is that their purpose benefits investors and the startup.
If startups offer pro rata rights as a standard for fairness toward investors, the investor maintains their equity, and the startup grows with an investor who benefits from the experience of seeing a company grow and learning how to safeguard themselves against losing ownership, voting power, and significant returns at later funding rounds.
Startups also benefit because offering pro rata rights helps generate investor confidence to commit larger sums in the early rounds.
The main benefits for investors who receive pro rata rights are:
- Long-term alignment: Ensures investors enjoy sustained influence in the company as they maintain their seat on the board of directors.
- Reduced dilution: Protects ownership percentage when new shares are issued in funding to reduce share value dilution.
- Access to high-performing deals: Guarantees participation in valuable later-stage investment opportunities.
An example of how this can work in practice is that an early seed investor can maintain their stake even at Series C, which allows them to reap higher returns at exit.
How Pro Rata Rights Work in Funding Rounds
The way pro rata rights work throughout the different rounds of funding is easy to understand when we observe the mechanics: An investor receives notification of a new funding round and then has the opportunity to invest additional capital proportionally to their current share.
The crucial aspects here are timing and sufficient liquidity. Timing is essential for investors to commit additional funding to maintain their ownership, but liquidity is equally significant, as funding is the most liquid asset, so investors must have this ready to commit to maintain startup liquidity, preserving their chance of getting a higher return. Another consideration around this issue is liquidity preference, which is a clause agreed early in negotiations to protect investors if a company goes into liquidation.
In practice, a company might raise $25M in the Series B round, and an original investor would be entitled to contribute proportionally based on their initial stake.
Investors should always be vigilant of shareholder agreements and term sheets to ensure they receive fair and favourable terms. An additional method of obtaining the most favorable terms is to agree upon an exit multiple, which ensures investors achieve the highest exit potential.
Pro rata rights are essential for allowing early investors to be able to continue to invest at later funding rounds. Doing so allows them to maintain their ownership and receive a high return as they exit. Investors must prioritize these rights during all early negotiations as a key long-term strategy.