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DefinitionPro rata rights (or pro rata) in a term sheet or side letter guarantee an investor the opportunity to invest an amount in subsequent funding rounds that maintains their ownership percentage.
Pro rata is Latin for “in proportion.” Most people are familiar with the concept of “pro rating” from dealing with landlords: if you’re entering into a lease halfway through the month, your rent may be “pro rated,” where you pay an amount of the rent that is in proportion to your time actually occupying the property.
Almost all investors try to negotiate for pro rata rights, because if a company is doing well they want to own as much of it as possible. After all, why not double down on a winner than use that same money to invest in a newer, unproven company? In the 2018–2019 fundraising climate, though, it’s safe to say we’re at “peak pro rata.” Everybody wants pro rata, even those who don’t entirely understand how it works or affects companies.
Some founders include a major investor clause in the term sheet, which reserves certain rights and privileges to those they deem “major investors.” Whether to grant pro rata rights to all investors or only those above a major investor threshold is a tricky decision for two reasons.
First, when companies use a major investor threshold to determine who gets pro rata rights and who does not, angel investors usually don’t make the cut. Angels hate this because it limits their ability to gain more ownership in a company they see themselves as having spotted and supported early on. VCs want the threshold because they don’t want to share pro rata rights with a larger group of investors. This is a major source of conflict between angel investors and VCs.
Second, companies are often optimizing to only sell a certain amount of the company to investors—20% is a common number for a traditional Series A.* The decisions around whether existing investors take their pro rata or some part of it are often negotiated as part of each subsequent round of financing, as new investors can’t always meet their ownership targets when existing investors all take their pro rata without the company selling more than they’re comfortable with. This is always a struggle—either new investors have to cut back how much they’ll invest or existing investors will have to cut back and not take their full pro rata. Companies and investors usually recognize the new round can’t dilute the founders too much and work together to negotiate a satisfactory deal.
When determining who to give pro rata rights to, founders need to take into account the risk of a deal breaking down because new investors and existing investors with pro rata rights can’t come to an agreement that works for everyone. While this may be rare, it’s worth knowing how your investors think about a situation like this before you find yourself there.
Just because a VC has pro rata rights doesn’t mean they have to invest anything into your next round. Founders should assume they have to earn investors’ pro rata for each subsequent round. Whether an investor takes their pro rata also depends on whether they hold reserves for companies they invest in. When talking with an investor, it’s worth asking them how they think about pro rata and whether they hold reserves for each of their investments to take their pro rata.
Once you’ve given pro rata rights, they tend to survive into the future. This has two implications. First, you’ll have to negotiate with everyone you gave pro rata rights to in previous deals, and if you’re doing well, early investors with pro rata rights are incentivized to want to own more of your company (they’re also incentivized to get the deal done so you can keep growing, however).
Second, other investors will ask who has gotten pro rata rights. If you’ve held to a bright-line rule, you’ll hold the moral authority of saying, “We’ve only given investors below X amount pro rata rights, and we don’t intend to change that.” This strategy may sound nice on paper, but consider what you’ll do if your dream investor wants in on the deal with a small check, but only if you grant them pro rata rights.
Pro rata rights can be calculated on a percentage, dollar-for-dollar, or fixed-sum basis.
Percentage basis. This is the most common. In this scenario, investors have the right to maintain their ownership percentage by continuing to invest more capital in subsequent rounds. For example, if an investor owns 5% of a company when their safe converts to equity, they can invest more money to maintain their 5% ownership at subsequent rounds.
Dollar-for-dollar basis. Much less common, this type of pro rata gives investors the right to invest an equal amount or less than the amount they invested in the first round. For example, if an investor puts $250K into the company in their first round of financing, that investor can invest up to $250K in future financings.
Fixed-sum basis. Even less common, investors who get pro rata on a fixed-sum basis maintain the right to continue investing an amount as agreed upon that is decoupled from the investment amount. For example, if an investor who invested $1M in a seed negotiates pro rata rights up to $500K, they will be able to invest up to $500K in each subsequent round of financing.
caution Dollar-for-dollar and fixed-sum basis pro rata rights can result in “super pro rata” rights, which companies should always seek to avoid.
Definition A super pro rata rights provision in a term sheet or side letter grants investors the right to buy a larger percentage of a company in a subsequent financing round. Super pro rata rights may be expressed as a multiple of the investor’s original ownership stake,* or they may result from dollar-for-dollar or fixed-sum pro rata rights where the amount the investor will invest in a subsequent round gives them a larger ownership stake than they started with.
For example, if an investor owns 5% of a company after their first investment and has the right to purchase any more than 5% of the company in a subsequent round, they have super pro rata rights.
dangerSuper pro rata rights are dangerous to companies because of the dynamic they create with existing investors and new investors.
First, super pro rata rights create ownership conflicts. Many VC firms have a rough target ownership percentage of 20% (in a traditional Series A), and 20% can often be the amount a company is selling in a round of financing. If a company grants an existing investor a 15% super pro rata right on the next round, it will be hard to find another investor interested in only having 5% ownership.
Second, super pro rata rights can signal risk. If a company grants a VC firm super pro rata rights and they decide not to invest past their percentage-basis pro rata despite having the right to do so, other firms may be led to believe there is a reason the inside investor does not believe in the company, which can scare the new investor off.