Pro Rata Rights

What are pro rata rights?

Pro rata rights (also known as “participating rights”) are a contractual provision that give investors the right to maintain their percentage ownership (and their voting power) even when new shares are issued in future equity raises. One important note is that the investor needs to put in additional capital in future rounds to maintain their equity percentage—if they choose not to invest, they get diluted.

How do pro rata rights work?

The concept of dilution plays a key role in understanding pro rata rights. Dilution occurs when a company issues new shares of stock, which reduces the ownership percentage of each existing shareholder. This can happen in a number of ways, such as when a company raises money through a round of equity financing, or when they issue a new options pool to employees.

In the event of dilution the investors pro rata rights are triggered, meaning they have the ability to purchase additional shares from the new allocation to maintain their ownership percentage.

Why are pro rata rights used?

Pro rata rights are often used to protect the interests of early investors, and to prevent the dilution caused by later rounds. By guaranteeing that early investors can purchase additional shares in future rounds, pro rata rights give these investors a form of protection against dilution.

Why do investors ask for pro rata rights?

Most early-stage investors will ask for pro rata rights as part of their investment, because they want to maintain their ownership stake and subsequent control in the company. Some later-stage investors may also ask for pro rata rights, although this is less common.

Why do startups agree to pro rata rights?

Startups may agree to pro rata rights because they need the investment capital that these investors can provide, and it’s a stipulation of the deal. They may also agree to pro rata rights because they want to attract high-quality investors, and these rights make the investment opportunity more attractive.

What are the terms associated with pro rata rights?

There are a few key terms associated with pro rata rights:

• Pre-emption rights: Pre-emption rights give investors the right to purchase new shares of stock before they are offered to anyone else so that they can maintain their ownership stake in the company.
• Anti-dilution protection: Anti-dilution protection is a contractual provision included as part of a stock purchase agreement, that protects early shareholders in a company from future dilution from down rounds.
• Liquidation preference: A liquidation preference gives investors preferential treatment in the event that the company is acquired or goes public. In most cases, investors with a liquidation preference will receive compensation before any other shareholders are paid.

Example of pro rata rights in action?

Let’s say an investor owns 10% of a startup (1M shares), and the startup decides to raise capital by kicking off a new round of equity funding. They will be creating and selling an additional 1M shares for $5 each (higher than the previous round of $2.5 per share). The pro rata rights are triggered, so the investor is given the opportunity to purchase additional shares to maintain their ownership percentage.

If the investor chooses to invoke their rights, they may purchase an additional 100K shares for $500K, bringing their total shares to 1.1M shares—resulting in the same ownership percentage (10%).

If the investor chooses not to invoke their rights, their ownership percentage drops to 9%.

How to calculate allocations resulting from pro rata rights?

To calculate how many new shares an investor is entitled to purchase by invoking their pro rata rights, use the following formula:

Number of new shares available to purchase = Investor's ownership stake (percentage) x Total number of new shares being sold

For example, if an investor has a 5% ownership stake in a company and the company is selling 1M new shares, the investor would be entitled to purchase 50K of the new shares.

What are the benefits of pro rata rights for investors?

Pro rata rights give investors the ability to maintain their ownership stake in a company after it raises new funding, to prevent them from being diluted.

What are the benefits of pro rata rights for startups?

Pro rata rights can help startups attract and retain high-quality investors, make the investment opportunity more enticing—subsequently helping them raise capital more quickly.

When are pro rata rights “good” for founders?

Pro rata rights are generally “good” for founders when the financial performance of the company is good. By giving existing investors the ability to maintain their ownership stake, pro rata rights can help a startup ensure their current investors stay motivated.

When are pro rata rights “bad” for founders?

Pro rata rights can be “bad” for founders when the company is not performing well and subsequently struggles to attract new investors. In this case, pro rata rights may actually hinder a startup’s ability to raise capital by giving existing investors too much power.

Are investors who have pro rata rights obligated to enact them?

No, investors who have pro rata rights are not obligated to enact them, but rather they can be exercised at the discretion of the investor. Also, investors are not required to fully exercise their rights—e.g. If the investor owned 10% of the company before, and the company raises a new round of financing which would bring their ownership stake down to 8%, they have the ability to purchase anywhere from 0-2%. Meaning they could end up with 8%, 8.5%, 9%...etc. following the new round.

When would investors waive their pro rata rights?

There are a few reasons why investors might waive their pro rata rights. Investors may waive their rights in a down round, if they lack the money to invest, or if they want to make room for new investors. In some cases, investors may also waive their pro rata rights as a show of support for the company.

Common pitfalls to avoid related to pro rata rights?

There is one very important pitfall to avoid when issuing pro rata rights: who you give them to.

While most investors will ask for them, and it's tempting to give pro rata rights to them, this approach is best avoided. The last thing you want to have happen, is to run out of room in a future round for new investors, because a previous investor with pro rata rights took the allocation. Worse yet, would be the perceived signal sent to the market if investors turned down their pro rata rights—this would make fundraising infinitely more difficult.