INSIGHTS

Pro Rata Rights Explained

February 15, 2022 | Justin Lurie, Matthew Moisan, and Steve Ryan

The term “Pro Rata Rights” is a frequently used term in venture capital financing.[1]  In this article, we offer a detailed summary of its practical implications.

Simply put, Pro Rata investment rights provide early investors the right to invest in later fundraising rounds in order to avoid the dilution that would occur as the company raises additional capital. In function, this means that the investors are able to purchase a certain percentage of the new fundraising round.[2]  While the definition is easy enough to understand, the implications of offering this right, or not, to early investors, are often overlooked.  Generally speaking, in later rounds, only certain investors receive this right.  However, in early stages, founders often grant this right to all investors in many cases without considering the implications on later financing rounds.

Why Do Investors Value Pro Rata Rights?

When making risky and highly speculative investments, such as those in early stage startup businesses, investors – both institutional and individuals – have an expectation that there is a possibility for a large return. Angel and venture investors see a high percentage of their investments unable to produce returns or even return their investment. When they do invest in a “winner”, a company that is going to create large returns, investors want to maximize their value.  However, the law does not provide that an investor is granted the right to continue to invest; rather, the company is free to accept investment from anyone.  Enter Pro Rata Rights – in which the company grants the investor the right to invest in a future financing round.   Typically, the right is limited, allowing the investor to only invest the amount of capital that would prevent it from facing dilution.

While investors can still earn a return without making a Pro Rata investment, it may be a significantly smaller amount than they would have realized had they continued investing and maintaining the percentage ownership they had when first investing in the company’s earlier, lower priced rounds.

Should I Offer Pro Rata Rights to all Investors?

At initial glance, a founder might, and often does, think that it is inconsequential to grant Pro Rata Rights to any early investor who requests the right.  After all, they took the big risk on you early on, shouldn’t they be entitled to continue to share in the success by participating in future rounds?  While that does seem logical, in practice this can create speed bumps (often minor) for founders during later stage financings.  A common speed bump that occurs is when a large, later stage investor would like to invest and take a large portion (if not all) of the fundraising round.  It is likely that their fund has certain principles; possibly a minimum investment amount or an ownership percentage threshold they need to achieve.  Sometimes due to the liberal granting of Pro Rata Rights to early stage investors, this new investor can’t mathematically achieve their investment goals because the early investors have a right to a significant portion of any future round.  In this scenario, the company will need to have early investors waive their Pro Rata Rights. Often times this is a simple ask, and early investors are happy to oblige to see the company continue to grow, however, this is not guaranteed and the ability to “hold up” the round has value.

Alternatively, an issue can arise when early investors holding Pro Rata Rights opt not to exercise them in a subsequent round.  This can happen for many reasons – they do not have the means, it is not part of their strategy, etc. – however, this can sometimes be seen as a yellow flag to the lead investors of a new round.  After all, the early stage investors likely had an inside look at the company for longer than the new investors, have an opportunity to continue investing, yet have chosen not to.  Again, they may have chosen not to for valid reasons having nothing to do with the trajectory of the company, but this can have the optics of a lack of confidence in the company.

Lastly, it’s worth noting, similar to the concepts of communication we discussed HERE, investors will likely learn who received Pro Rata Rights and who did not.  Thus, we’d encourage honest communication to investors as to the terms received by other investors.

While this is not an exhaustive list of issues that may arise in the granting of Pro Rata Rights, it does highlight the importance of being thoughtful about granting this right.  In the event you need to grant Pro Rata Rights to investors, consider doing so with a clear criterion on who will receive such rights.  The situational needs of businesses vary and sometimes granting Pro Rata Rights is unavoidable. Companies should consult with their legal advisor for a more in-depth discussion of the implications prior to agreeing to these rights.

[1] Pro Rata Rights comes in many different forms (Participation Rights, Preemptive Rights, Rights of First Offer, and others).  For the purpose of this post, we will group all forms of participation rights in the definition of “Pro Rata Rights”, however, noting that these different forms can and often times do, differ in their mechanics.  Such differences are outside of the scope of this post.

[2] Sometimes such pro rata rights only provides for the preservation of a portion of investors ownership percentage.

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