Pro rata rights give current investors the option to purchase enough shares in future rounds of funding to maintain their current equity position. This ensures that their stake in the company remains consistent and that they are not diluted by new investors who come on board later.
What Are Pro Rata Rights in Startup Funding?
Pro rata rights provide protection for investors who have already invested in the startup and want to maintain the value of their investment as the company grows.
Negotiating and Structuring Pro Rata Rights in Investment Agreements
Pro rata rights are a crucial aspect of a startup’s funding round and are typically negotiated as part of the investment agreement with investors. They are usually included in the term sheet that outlines the investment details.
The structure of pro rata rights can vary depending on the specifics of each investment deal. For example, some investors may have priority over others in exercising their pro rata rights. There may also be limitations on the number of shares an investor can purchase through their pro rata rights or restrictions on when they can exercise them.
Startups usually grant this right to some investors, but not to all. It is a preference that is often reserved for an investor who has made a significant investment or a particularly helpful investor (major investor).
How to Calculate the Number of Shares an Investor Is Entitled to Purchase Through Their Pro Rata Rights
Calculating an investor’s pro rata rights can be a bit tricky, but it’s important to get it right in order to ensure that everyone is getting their fair share. The formula for calculating pro rata rights is fairly straightforward:
Pro Rata investment amount = % ownership prior to round * total $ invested new round by all investors
For example, let’s say that an investor currently owns 5% of a company with a pre-money valuation of $10 million. If the company raises $5 million in new funding, the calculation would look like this:
5% * $5,000,000 = $250,000
This means that the investor would be entitled to purchase up to $250,000 worth of new shares in order to maintain their 5% ownership stake. Of course, not all investors will choose to exercise their pro rata rights, and some may choose to invest more or less than their calculated amount.
For a deeper dive into pro rata calculations, check out this post on Foresight.
The Impact of Pro Rata Rights on a Company’s Ability to Raise Additional Funding Rounds
While pro rata rights are generally considered beneficial for founders, they can also lead to conflicts between existing and new investors. Pro rata rights can impact a startup’s ability to raise additional funding rounds. If early investors choose not to exercise their pro rata rights in subsequent funding rounds, it could signal to new investors that they lack confidence in the company’s future prospects. This could make it more challenging for the startup to attract new capital and ultimately harm its chances of success.
On the other hand, if existing investors do choose to exercise their pro rata rights, it can demonstrate their continued commitment and belief in the company’s potential. This can be highly attractive to new investors, who may see it as a positive sign and be more willing to invest.
However, if every existing investor exercises their pro rata rights, it may raise another issue.
In a typical Series A, a startup is selling a 20% stake in their company. So, there are only so many shares to go around. If new investors have a specific equity target in mind and they are unable to achieve that target because early investors are crowding them out, they may pass on the deal. After all, if all early investors are exercising their pro rata rights, that leaves little room in the funding round for new investors.
Pro Rata Rights Do Not Guarantee Future Investment
Founders should understand that granting pro rata rights to investors does not guarantee their investment in future funding rounds. Investors may exercise their pro rata rights depending on the availability of reserves specifically earmarked for follow-on investments. Therefore, founders must discuss pro rata with investors to understand their stance and whether they set aside reserves for each investment to exercise their pro rata. Transparent communication with investors will help founders make informed decisions for future financing rounds.
Best Practices for Founders and Early-Stage Investors When Negotiating Pro Rata Provisions
Negotiating a term sheet with pro rata provisions doesn’t have to be overly complex. Just keep these tips in mind.
- Be Transparent About Your Intentions: It’s important for both founders and early-stage investors to be clear about their intentions regarding pro rata rights from the outset. This means discussing who’s getting these rights, how these rights will be exercised in future funding rounds, and any potential conflicts or disagreements that may arise.
- Consider the Impact on Future Funding Rounds: When negotiating investment agreements with pro rata provisions, it’s important to consider how these provisions will impact future funding rounds. For example, setting aside too many shares for pro rata rights could make it difficult for the company to attract new investors in the future.
- Work Closely With Other Investors: Coordination among early-stage investors can help them maximize their returns while still maintaining some control over the startup’s future. By working together to ensure that everyone’s interests are being met, investors can avoid unnecessary conflict and increase their chances of success.
- Get Legal Advice: Finally, both founders and early-stage investors should seek legal advice before entering into any investment agreement with pro rata provisions. An experienced lawyer can help ensure that the agreement is fair and legally binding for all parties involved. If you’re looking for an experienced startup law firm, click here to connect with us.
By following these best practices, founders and early-stage investors can negotiate investment agreements with pro rata provisions that protect their interests while still allowing the startup to attract new investment capital and grow its business over time.