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 $1 million 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.
Often, when a company or a round becomes “hot”, early investors looking to exercise pro rata rights can sometimes find the founder is now nowhere to be found. In these situations you need to be extra careful, as the value of your rights is probably substantial, and no-one is going or hunt you down and ask for your money in this particular case. And what should you do if you don’t have sufficient capital to maintain your stake through a large round?
Typically, pro rata rights can be exercised by either the original investor or a designee. Which means that you can sell or transfer your pro rata rights to someone who has the capital to actually exercise them. In fact there are whole firms that exist purely for the purpose of monetizing investors pro rata rights in situations where they do not have the capital needed to exercise them.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. And this also means keeping track of follow on rounds so that you don’t get “lost in the shuffle” as an early investor. Platforms like 1000 Angels can be helpful tools in the effort to track your investments and maintain your equity stake in the ones that are successful. Don’t underestimate the value of pro-rata rights.