The case for and against pro-rata rights
By: Christoph Janz
Tags: Venture Capital, Startup

The case for and against pro-rata rights

What can we learn from nuclear physics to make pro-rata discussions less radioactive?

One question that inevitably comes up in every investment round (except for a startup’s very first one) is whether existing investors participate in the financing, and if so, to what extent. As Fred Wilson wrote a little while ago, it’s become an increasingly controversial question in recent years and has led to many arguments between founders, early-stage investors, and later-stage investors.

Pro-rata 101

If you’re not familiar with the topic, here’s a quick primer. If you know the basics of pro-ratas, you may want to skip the next few paragraphs.

If a company raises capital by issuing new shares to a new investor, the total share count of the company increases, and consequently, the ownership percentages of existing shareholders decrease. That process is called “dilution”, a term that, before raising my first VC round in 1998, I only knew in the context of homeopathy. Homeopathic dilutions are typically so extreme that not a single molecule from the original substance remains in the solution, which means that homeopathy is a $5 billion business of selling nothing (but water and alcohol). The amount of dilution in a VC round (or any equity financing) depends on the valuation of the company and the investment amount and is typically in the 15–30% range.

As a general rule, all shareholders in a company have the right to participate in a new financing round on a pro-rata basis. So every shareholder can decide to invest more money to partially or completely offset the dilution or not invest and be diluted accordingly. The amount that a shareholder needs to invest to completely offset the dilution can be calculated by multiplying the total volume of the round with the shareholder’s ownership percentage before the financing.

An early version of pro-rata rights from the Prussian Commercial Code as of 1862 (!)

That amount is the shareholder’s “pro-rata amount” or just “pro-rata”. Note that if the company’s ESOP is increased as part of the financing round, as is often the case, the shareholder will still end up with a lower ownership percentage after the round. Pro-rata rights usually don’t protect from this type of dilution.

The right to participate in new financing rounds on a pro-rata basis, the “pro-rata right”, is a fundamental right that protects the interests of minority shareholders e.g. in highly dilutive financing rounds. In many countries, pro-rata rights are enshrined in the law, i.e. shareholders, by default, have a pro-rata right in these legislations.

The problem(s) with pro-ratas

That, in a nutshell, is what a pro-rata right is. So what’s the problem? There are two very different scenarios:

Scenario #1:

The company is doing OK but not great. Fundraising is somewhat difficult, and to avoid negative signaling, the founders want existing investors to participate. This can put existing investors in a situation where they would prefer not to invest more money, but doing so might send such a bad signal to prospective new investors that it could jeopardize the financing. As you may know, we’ve addressed this issue with our “Series A pledge”. Whenever we make a seed investment, we commit to participating in the Series A to avoid any potential concerns around signaling from the get-go.

Scenario #2:

In this scenario, the company is doing well and is becoming “hot”. In these cases, there is usually “too much money on the table”, i.e. the new investor(s) want to invest more rather than less in order to reach their ownership targets, and existing investors would like to participate, too.

This is the scenario Fred Wilson wrote about:

“In the last ten or so years, companies, lawyers, boards, management teams, founders, and in particular late stage investors have been disrespecting the pro-rata right by asking early stage VCs to cut back or waive their pro-rata rights in later stage financings. […] I think this is bad behavior as it disrespects the early and critical capital that angels, seed investors, and early stage VCs put into the business to allow it to get to where it is. If the company agrees to a pro-rata right in an early round, it really ought to commit to live up to that bargain.”

Here’s an example:

A new investor, which the company is keen on getting on board, insists on getting a certain percentage of the company, say, 20%.

The founders don’t want to get diluted by more than, say, 23%.

As a result, only 13% of the round (3/23) is available to existing investors, even if their pro-rata right amounts to much more, say 30% of the round.

In this situation, existing investors are often asked (sometimes urged, and occasionally more or less forced) to give up their pro-rata rights, or large parts of them, to make space for the new investors. As Fred says, this can be extremely frustrating for existing investors for whom the pro-rata right might have been an important part of the initial deal. Things get particularly nasty if existing investors are treated differently, especially if larger existing investors use their voting powers to waive pro-rata rights for all existing investors while securing allocations for themselves.

Giving up pro-rata rights in your best-performing portfolio companies is particularly bad if you consider that investors often end up participating in financings of companies that aren’t doing so well in order to support them (see Scenario #1 above). This effectively means adverse selection — you have to participate in companies that aren’t doing well, and you cannot participate in those that do well.

At the same time, it’s rational that founders want to give a larger allocation to new investors: Existing investors will continue to support the company whether their stake gets diluted or not. Therefore, founders would rather use a larger allocation to get new investors on board and incentivize them. In a way, allocations can become a currency to get value-add from investors.

If a company raises several rounds of funding, pro-rata rights can become a real burden. Imagine that at some point, investors own 60% of a company. If that company wants to raise, say, $30 million and all investors take their full pro-rata, $18 million will come from existing investors, and only $12 million will be available for new investors. That might not be enough for the type of investor which the company wants to bring in at that stage of the journey.

What could a fair solution look like?

It’s a situation in which all stakeholders — founders, existing investors, new investors — have legitimate interests that can’t be fully aligned. What could a fair solution look like?

There is a spectrum of opinions:

On one end of the spectrum, there is the view that pro-rata rights are sacred because they are, well, rights. Pacta sunt servanda, “agreements must be kept”. ;-) I can relate to that view, but I don’t think it can be applied categorically. As explained above, ever-increasing pro-rata rights can become a massive burden for companies.

On the other end of the spectrum is the view that pro-rata rights can basically be ignored and must be waived whenever there’s not enough space in a financing round. This is the most convenient solution for the company and maximizes the founders’ ability to use pro-ratas as a currency for getting value-add, so it has some merits. However, if a company doesn’t want to deal with pro-rata rights, it would be more honest and straightforward not to grant them in the first place and have the hard conversation before taking the investor’s money.

What if pro-rata rights had a decay rate built-in?

Here’s an idea. What if participation rights faded out over time? What if investors had a full pro-rata right in the round following their initial investment, but in each round thereafter, their participation right was cut in half? Like a radioactive element that loses 50% of its energy in each half-life.

So a seed investor, for example, could do 100% of their pro-rata in the Series A, 50% in the Series B, 25% in the Series C, 12.5% in the Series D, and so on. Likewise, a Series A investor could do 100% in the Series B, 50% in the Series C, and so on. To a certain extent, this is how things often play out naturally anyway. But I’m wondering if agreeing on it upfront could make it more predictable for everyone, and make the sometimes explosive pro-rata discussions less radioactive. :-)

Would a built-in decay rate make pro-rata discussions less radioactive?

When I shared this idea with Tilman Langer, he rightly pointed out that there would be various practical difficulties. But the current standard — investors keep their pro-rata rights (almost) forever, but frequently it’s a right that exists only on paper, while companies are burdened with an ever-increasing stack of pro-ratas — doesn’t look particularly smart. So maybe the radioactive approach is worth a shot?

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