An Explanation of Pro Rata and Super Pro Rata Rights
Picture this: you’re an angel investor who bought a 10% stake in the next Google’s pre-seed round. About a year later, the company begins raising its seed round. Other investors see the same potential in the company that you did when you first invested and the deal heats up. A big venture capital firm fills the entire round, diluting your stake in the company significantly. You now own 3% of the company and have significantly less control over company matters. You had little say in this happening despite being one of the first people to believe in the company and invest when few others were willing to take on the risk.
Pro rata rights exist to avoid the exact problem described above.
Pro Rata Rights
Pro rata is a latin phrase that literally translates to “according to the rate,” but in the venture business, it is used to mean “proportionally.” In angel investing and venture capital, pro rata rights give the investor the right (but not the obligation) to participate in one or more future financing rounds to maintain their percentage stake in the company. In the above scenario, pro rata rights would have given the angel the right to commit a follow-on investment that would maintain their stake in the company.
Pro rata rights allow early-stage investors to maintain their percentage positions in their most successful companies as they scale, opening up investors to greater return potential than they would have from solely owning their initial stake. Early-stage investors shoulder the heightened risk associated with discovering high-growth companies before they have achieved significant market traction, so once a portfolio company has shown promising progress, having the right to reap additional rewards from a successful bet is invaluable. In companies where maintaining a certain percentage of ownership is a requirement for keeping a board seat, pro rata rights also allow investors to retain this oversight. Because of these benefits, and the fact that today, startups grow faster and raise larger rounds than ever, early-stage investors are increasingly insistant on being granted pro rata rights.
For entrepreneurs, pro rata rights can be a double-edged sword. Although not every investor will exercise them, pro rata rights offer the partial benefit of securing financing for future rounds. An entrepreneur can reasonably guess that if their company is doing well, investors in previous rounds will want to maintain their percentage stakes in the company in future rounds. This is fantastic when the entrepreneur’s early investors provide significant value to the company, whether through opening up their networks or lending expertise and advice. However, providing pro rata rights also means investors who provide little value beyond their investment capital or those who have ulterior motives for investing in the company are allowed to crowd out the valuable investors who may join the company in subsequent rounds. Additionally, offering pro rata rights in too many rounds can severely dilute a founder’s stake in their business. Nonetheless, in the early stages, entrepreneurs will risk losing investor interest if they do not offer pro rata rights.
Super Pro Rata Rights
Super pro rata rights are a right of first offer to purchase up to 50% of the total amount of the next round raised. Despite the inclusion of “pro rata” in the name of this clause, super pro rata rights would more aptly be described as “disproportionate” in the follow-on opportunity guaranteed to investors. This uncommon deal term was first created by famous angel investor Jason Calacanis, who frequently includes super pro rata rights in terms sheets at his accelerator, Founder University. Since the advent of super pro rata rights, they have been predominantly adopted by angel investors and accelerators such as Y Combinator, who contribute significantly to the success of the startups they work with.
Super pro rata rights pose a number of unique advantages and disadvantages to founders and investors alike. Many investors and entrepreneurs dislike super pro rata rights because they effectively prevent other investors from participating in later rounds. Having more investors in a company prevents a greater number of investors from supporting competitors, gives the entrepreneur more networks and more expertise to lean on, and prevents any one investor from having too much control in a company. Calacanis, who pioneered this deal term, does provide some of the benefits of having various investors participate in the round by investing using his angel syndicate. Nonetheless, not every investor that uses super pro rata rights employs such strategies. As such, many venture capitalists will push to repeal super pro rata rights given to earlier investors, which can be an incredibly painful process that harms the company’s relationships with investors who had these rights.
Super pro rata rights pose an advantage to entrepreneurs in that they effectively guarantee a significant portion of the next financing round being raised. This lessens the often vast amount of time entrepreneurs spend fundraising, giving founders more time to focus on building the company. However, by allowing early-stage investors to have greater percentage ownership in subsequent rounds, super pro rata rights amplify the “double-edged sword” of pro rata rights, making it even more important to be selective in choosing early-stage investors.
Super pro rata rights also prevent the phenomenon of investors with large funds buying out entire funding rounds. When large funds fill rounds, it blocks entrepreneurs from the benefits of having multiple investors in the round more so than super pro rata rights do, since super pro rata rights still allow for at least 50% of the round to be filled by other investors. Additionally, the large funds often win the privilege of filling entire rounds for competitive deals by agreeing to higher valuations than other funds could stomach, and by buying out founder shares in an effective “bribery” that allows the large fund to be the only investor in the round. By preventing this pheneomenon, super pro rata rights lead to more accurate, reasonable valuations in later rounds, as well as (in some cases) a more even playing field for smaller funds to participate in competitive deals.
Lastly, by allowing early investors a larger portion of a future round at the outset, it forces outside investors interested in that round to compete over a smaller portion of the company. Although the company obtains less investors overall, the entrepreneur can be more selective and choose only the investors who offer the best deal terms and value-adds (introductions, expertise, advice, etc.).
It is clear why super pro rata rights are controversial, as they significantly alter fundraising dynamics and more broadly, outcomes for portfolio companies. Ultimately, it is rare to see super pro rata clauses on term sheets, while pro rata rights are quite common in early-stage deals. No matter how common given deal terms may be, it is paramount to take careful consideration of how accepting these terms will affect one’s venture in the long-term.
Excellent considerations from investor and offerer points of view. Thanks for the thought provoking article.