This oft-quoted adage from Shakespeare’s The Tempest perfectly captures how your company’s prior fundraising history sets the stage for future rounds. Pro rata rights, the clause asserting your investor’s option to participate proportionately in your next round, affect the dynamics of your subsequent financing event. While your investors are in no way obligated to maintain their percent ownership in your company, it is a way for them to manage risk so that they are not significantly diluted down the line. If your company is extremely successful and many investors want a piece of the pie, pro rata rights essentially confirm a slice of the pie for those investors who believed in your company when it was a riskier opportunity.
Pro Rata Rights In Action
Let’s assume that you are an entrepreneur raising your Series A round, and you have granted pro rata rights to your investor Ivan. Ivan invests $70,000 in your Series A, with a $7,000,000 post money valuation, effectively owning 1% of your company. When your company is super successful and decides to raise a Series B round not too long later, Ivan is wondering how much money he has to invest to maintain is 1% ownership. This next round will be a $5,000,000 round at a $13,000,000 pre money valuation (making the post money valuation $18,000,000). Given this information, Ivan will need to invest $50,000 to maintain his 1% ownership. If Ivan decides not to invest in this round, he will be diluted 27%, yielding a 0.73% ownership of the company. Ivan’s pro rata right, in this scenario, is the $50,000 investment in the Series B round.
Here is the calculation being made:
$ Required To Maintain % Ownership = % Ownership Investor Wants To Maintain * Number of Shares Being Issued * Share Price For Round
Although it is not easy for an early investor to own more than their initial percent stake in the company as it matures, pro rata rights ensure that these investors are able to maintain their initial stake. These early investors were the first to believe in your company, and pro rata rights are a way of rewarding them for this initial trust. Sometimes, investors will exercise their pro rata because they are excited to reap the financial rewards of owning more equity. Other times, investors will exercise their pro rata rights as a way of maintaining a board seat in the company (if the board seat was granted with a caveat of a certain ownership threshold).
Now imagine if all your investors are promised pro rata rights and they all decide to exercise these rights in your next round. This would total to the amount of the round and allow for no new investors to join in. Therefore, in the early stages of company formation, founders should be as choosy as possible when it comes to accepting money from investors and granting pro rata rights. An investor with pro rata rights could block out a strategically important potential investor in a subsequent round.
Another consideration that founders should keep in mind is that pro rata rights protect investors in the event there is an upside for a company. These successful startups are where venture capitalists make most of their money, so the guarantee to be able to continue to invest in a company that proves successful is very valuable. Furthermore, pro rata rights can be transferred between investors. So if Ivan has pro rata rights to your company and decides not to invest the $50,000, his buddy Isa could pay the $50,000 and use his right in order to get a seat at the table.
Pro rata rights are an important component of any company’s financing negotiations, and can be both a blessing and a curse to founders. While pro rata rights help narrow down the list of potential investors in a company’s next round, they also guarantee that a company is wedded to their initial investors.
Pro rata rights are of tremendous importance to both the company and its existing (and new!) investors. Luckily, Shoobx makes planning your next round almost as fun as the final closing. By automating all pro rata calculations and providing you with versatility during the modeling process, forecasting has never been easier!