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ACADEMY: What are pro rata rights?

Posted by Erica Duignan Minnihan on Jun 14, 2016 11:49:00 AM

 

This is one of the more complex but potentially very important aspects of early stage investing. Pro-rata rights help ensure that as an early investor in a company you have the option to maintain your equity stake as the company raises more capital. Let’s say you acquired 10% of a company that was valued at $10 million post money in 2015. The following year, the company starts to really take off, and decides to raise $10 million at a $40 million dollar pre-money valuation. Without pro-rata rights, the company or its new investors could refuse to let you participate in the round, and your stake in the company would diminish from 10% to only 4%, significantly reducing your potential return if you believed this company had the potential to reach a billion dollar valuation. Assuming you did have pro-rata rights, and were able to successfully exercise them, you would have the option to invest another one million dollars in the $10 million round in order to maintain your 10% ownership stake in the company. As a result, if the billion dollar exit were achieved, your return would be closer to $100 million than the $40 million you would have gotten without pro rata rights. So you can see why they are potentially very valuable. The trick however, is actually being able to exercise them, particularly in situations when their value is obvious to the other investors in the subsequent rounds. Some well-known investors feel that the terms they negotiate in subsequent rounds are a result of the strategic value they add, and can often balk at early investors exercising their pro-rata rights. As an investor it’s up to you to make sure that you advocate for the exercise of your pro-rata rights should the opportunity arise. Don’t underestimate the value of pro-rata rights.

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Topics: Venture Investing Academy