In financial terms, pro-rata rights allow an investor to maintain their portion of ownership in a company when the company takes on new investors.

Company Valuation and Pro-Rata Rights

It is important to understand the role that the valuation of your business has on pro-rata rights for other investors. This is important because the angel or venture capital investor dilutes the shares of other owners. Other owners in early-stage businesses are typically the owner (or owners) and friends and family members. Initially your company may look like this:

  • Owners/Founders - 50 percent equity each
  • Friend and family investors – each owner/founder surrenders 5 percent and 10 percent is given to friends and family (founders/co-owners now have 45 percent each)

At this point, you will typically have registered your company with stock to ensure you can actually issue stock to family or friends who invest in the company. As part of your overall structure, your equity positions now look like this:

  • Owners/Founders - 37.5 percent each (X2 = 75 percent)
  • Friends/Family - 5 percent
  • Reserved for future investors or employees – 20 percent

If you now need a sizable investment to keep your business going, you will seek out financing from an angel investor. Now company valuation comes into play. Let's assume for a moment that an angel investor believes your company is worth $1,000,000. Then they decide they are willing to invest $200,000 into your company.

To determine the investor's percentage of ownership, you must take the valuation into consideration:

  • Value established by investor = $1,000,000
  • Investment by investor = $200,000
  • New company value = $1,200,000

To determine the investor's "share" of equity, you divide what they invested into the new company value: +200,000/1,200,000 = 0.016667 or 16.7 percent. Going forward, the investor's share is based on their "pro-rated" investment of 16.7 percent (not the original 20 percent you had set aside).

Each time a new investor invests, they increase the valuation, thereby diluting the original investor's percentage. For example, let's say another investor adds $200,000 in capital to your company at the $1,200,000 valuation. The new company valuation would be $1,400,000, and their investment would net them 14.3 percent of the company (0.142857).

At this point, the original investor's pro-rata rights would kick in. They would have the option to buy enough shares from the company to bring their percentage back up to 16.7 percent of the company. Though the company will receive extra cash, this will inevitably dilute the founders' percentage of ownership.

Why Pro-Rata Rights Are Important to Investors

Investors are interested in pro-rata rights because as your company grows, they do not want their equity diluted. Simply put, the more successful you are, the more involved investors wish to be in the company. Keep in mind, as you take on additional investors, your business value grows. The more investors involved, the lower the percentage the initial investors own, unless they exercise their pro-rata rights.

Why Pro-Rata Rights Are Important to Entrepreneurs

One of the good things about pro-rata rights is you may be holding early investors long-term. While not every investor will exercise those rights, you may be able to use the fact you have investors, who have these rights, as a negotiating tool for future financing (see the markup game). As a founder, you may also be able to sell portions of your equity to an investor who wishes to exercise their rights. You will be diluting your ownership portion, but you have an increase in personal wealth nearly immediately.

Angel Investors and Pro-Rata Rights

If you are seeking out angel investors, chances are they are investing in only a few companies they think are going to prosper. In most cases, they will want to have a pro-rata agreement. This is because they do not want to miss out on future rounds of financing.

What to Be Aware of with Pro-Rata Rights

When negotiating with an investor about pro-rata rights make sure you are not boxing yourself into a corner. If you go through multiple stages of financing and give pro-rata rights at each stage, you could find yourself with a host of problems. Larger investors often want a bigger piece of equity; if you have promised to keep early investors involved in funding, you could face challenges with new financing.

Pro-Rata Rights and Management Decisions

Angel investors and venture capital companies often wish to have a say in your company's management. This often involves putting a qualified person on your board of directors. As you give up equity in the company, you could have minority investors who hold board positions.

Pro-Rata Rights and Future Financing

Keep in mind pro-rata rights may also hamper your ability when it comes to securing future financing. Investors who hold those rights have the option (but not the requirement) to invest more money. Should they decide to exercise their rights, your freedom of action in securing new financing could be limited.

There are three stages of second-round financing that could impact pro-rata rights:

  • New investors want to get involved with a successful company
  • New investors want to dictate how much equity is available for existing investors
  • An agreement of allocation is worked out between the founder, and the new and past investors

In financial terms, pro-rata rights allow an investor to maintain their portion of ownership in a company when the company takes on new investors.

Investors and Pro-Rata Rights in Later Rounds

Many people wonder if investors always exercise their pro-rata rights in later investment rounds. An investor's decision to exercise their rights will almost always depend on the amount of an investment round. Imagine an investor paid $500,000 for a 10 percent ownership stake in a company. If the company later raises $20 million, the investor may not be able to afford the $2 million required to maintain their ownership percentage.

An investor's strategy will depend on how much risk they are willing to assume. In some cases, the investor may choose to take up their pro-rata rights and other times they may decide not to exercise these rights. It's also possible the investor will decide only to take a portion of their pro-rata rights.

Additionally, be aware that many early company investors prefer lower initial prices because it means they won't need to invest as much in a later round to maintain their ownership stake. In later funding rounds, new investors may want initial investors to put in money to prove the early investors still have faith in the company. On the other hand, some new investors may want the early investors not to exercise their pro-rata rights, as this will allow the new investor to take a larger portion of the investment round.

Because pro-rata rights really come down to the individual investor, it's common to be confused by the process. For instance, pro-rata rights can easily result in conflicts, as early investors that insist on having pro-rata rights will often do everything they can to maintain these rights. Certain investors might decide not to take these rights because they believe the company has been incorrectly valued.

Certain early investors choose not to take-up their rights for a specific reason. Depending on when you invest your money, you can increase your average price to a tremendous degree. In some cases, you may be able to own a large percentage of the company with a high valuation without needing to invest the same amount of money as later investors.

Do Angel Investors Prefer Pro-Rata Rights?

In the past, it was uncommon for angel investors to insist on pro-rata rights. The main reason for this was that angel investors believed that writing a large check in later financing rounds in order to maintain pro-rata rights didn't make financial sense. Generally, only large investors were granted pro-rata rights.

Today, more and more angel investors are insisting on pro-rata rights. For starters, there are many more wealthy angel investors than there used to be and these people want to make sure that their investment is protected. Also, the value of pro-rata rights has increased from what they once were. Tech companies now grow much more quickly than in times past, and companies are now able to raise much more money in later financing rounds. Because so much money is involved, angel investors are increasingly requesting pro-rata rights so that they don't miss out on a big return on investment.

Limited Partners and Pro-Rata Rights

Limited partners are typically the first investors in venture capital funds and these partners are also taking interest in pro-rata rights. Some limited partners that invest in venture capital funds include:

  • Public pensions
  • University endowments
  • Insurance companies
  • Sovereign wealth funds

It was not always common for groups such as these to make direct investments in venture capital funds. A direct investment strategy usually means that you would invest in a venture capital fund and then later diversify. At that time, you would directly invest in one of the individual companies in the venture capital fund's portfolio.

In the past, it was hard for limited partners to determine whether it was worthwhile to invest in a given venture capital fund. Thanks to the explosion of seed funds in the modern era, and the value of pro-rata rights, limited partners can now find beneficial investments across multiple industries.

Pro-Rata Right Conflicts Between Funding Rounds

Entrepreneurs have not been historically concerned with how investors exercised their pro-rata rights. Between investment rounds, there is often some sort of give and take between early investors and new investors. It was common practice for new investors to insist early investors provide more money to prove the company was financially sound.

Modern investors care more about acquiring large ownership percentages than they do verifying the confidence of early investors. It is this desire for large ownership percentages that now causes conflict between early-stage and late-stage investors.

In the option of early investors, large later round investors are interfering with the early investor's pro-rata rights. On the other hand, large investors believe early investors should refrain from taking up their pro-rata rights because of the large amount of money being provided in later investment rounds. Every company must decide how to negotiate these issues so that both groups of investors are pleased.

Pro-Rata Rights and Entrepreneurs

The disagreement over pro-rata rights between early investors and late-stage investors often puts entrepreneurs at a disadvantage. For example, in order to keep all investors satisfied, an entrepreneur may inadvertently sell too much of their company, diluting their ownership stake and eliminating the benefits of seeking investments.

With the right strategy, you can use the investor's desire for pro-rata rights to your advantage. For example, it has now become common practice for company owners to sell off some of their personal stock to decrease their personal risk. Selling personal stock in this manner is a direct result of the increased desire for pro-rata rights.

Entrepreneurs should be sure they are treating investors as investors. At one time, angel investors were known for keeping the interests of the company's founder in mind. Now that angel investment is a big business, the only concern of investors is getting a big return. While it's important to balance the needs of investors, entrepreneurs also need to be certain seeking financing for their company isn't hurting their long-term interests.

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