When investors provide funding to startups, they often negotiate certain rights and privileges to protect their interests and maximize their returns. One such right is known as “pro rata rights.” In this post, we delve into the concept of pro rata rights, explaining what they are and providing example to illustrate their significance for both investors and startup founders.
What are Pro Rata Rights?
Pro rata rights, also known as “preemptive rights,” are a contractual provision that gives investors the option to maintain their ownership percentage in a company by participating in subsequent funding rounds. In other words, if an investor owns a certain percentage (x%) of the company before a new funding round, pro rata rights allow them to invest additional funds in that round to retain their ownership percentage (x%) even if the round dilutes their ownership to a lower percentage (y%).
The Importance of Pro Rata Rights:
Pro rata rights are crucial for investors as they enable them to protect their initial investment and preserve their ownership stake as the startup progresses and raises more capital. For founders, pro rata rights provide the opportunity to maintain a relationship with existing investors who have demonstrated confidence in their venture. By allowing investors to participate in subsequent funding rounds, pro rata rights can contribute to a more stable investor base, continuity of support, and potential access to additional expertise and resources.
Example Scenario:
Let’s consider a hypothetical scenario to illustrate how pro-rata rights work in practice. Imagine a startup, ABC Tech, has completed its initial funding round, raising $1 million from an investor, Venture Capital Partners (Investor#1), in exchange for a 10% ownership stake. The company is now valued at $10 million.
Round 1 When Investor#1 invests $1M and values ABC at $10M after investment (Post money valuation). So Investor#1 gets 10% ownership of the company ($1M/$10M). Assume $1 = 1 share, after this round of fundraising, so you have 10M shares with a price of $1 each making the company worth $10M, and since Investor#1 owns 10% means they have 1M shares.
Round 2 after months and years where startup is raising $20M from new Investor#2 for a $100M post-money valuation (so according to you and Investor#2 the current worth of your startup before investment = $100-20M = $80M = pre-money valuation).
So each of the existing 10M shares is now worth $8 (8x up from $1) before the investment has even happened (WOW!). Investor#1 still owns 10% shares of this company so their existing 1M shares are now worth $8M!
If Investor#1 does not invest in Round 2, they will still own $8M of a $100M company or 8% (= diluted to = $8M/$100M). So they were diluted by ((10-8)/10) x 100 = 20%.
So Investor#1 decides to exercise their pro rata rights to maintain 10% ownership of the new-and-improved company they need 2% more shares of this now $100M company that your startup will be after investment = 2% of $100M company = (2/100) x $100M = $2M which they will need to pay if they want 10% of your company instead of 8%.
You can usually also compute this as 10% (% ownership that Investor#1 needs to retain) of $20M (amount being raised) in this round.
So by investing $1M in Round 1 and $2M in Round 2 (total $3M) Investor#1 is able to maintain 10% of a $100M company, and instead, Investor #2 had to pay $10M to get the same 10% (or $20M for 20%) in Round 2. This may seem unfair to founders but remember that Investor#1 was the first to believe and invest in you and your company so they get to enjoy the benefit of having taken that risk.
You can negotiate this so only those investors who have > 5% ownership in the company get to enjoy pro-rata rights, which shows the bigger investors that you are financially literate and know whats best for your company.
Investors who own <5%, and especially those who own <1% (like 0.1%) should not have these rights otherwise you may end up chasing small checks/cheques of $1-100K from previous investors when you are trying to raise $20M in Round 2 from bigger investors.
Conclusion:
When negotiating investment terms, both founders and investors should carefully consider the inclusion and specifics of pro rata rights to align their interests and foster a mutually beneficial relationship throughout the startup’s journey.