Pro-rata rights allow investors to maintain their equity ownership in future financing rounds, preventing dilution as new investors come.
Pro-rata rights allow investors to maintain their equity ownership in future financing rounds, preventing dilution as new investors come in. This enables them to continue investing as the business matures and progresses through financing cycles.
Pro-rata comes from the Latin word “in proportion.” What this means is that whenever the investor makes an investment, and you agree to that pro-rata right with them, in a future financing round, they will be able to execute that pro-rata right, which allows them to maintain their equity ownership when new investors are coming. So, essentially, in every round of financing, you’re going to have new investors, you’re going to be issuing new shares, and that is going to dilute the position of every existing investor in the business. Hopefully, the valuation of the business is much bigger, but it dilutes the position and the ownership of everyone. With that pro-rata right, that investor gets the opportunity to execute the pro-rata right so that they can continue investing in the business as the business matures and goes from financing cycle to financing cycle so that they can continue to
maintain their equity ownership in the business. In terms of asking the question, do investors always activate their pro-rata rights? The answer is: no. There are going to be multiple factors that are going to determine whether that investor wants to continue reinvesting in the business or not. Some of those factors are the following. This is going to determine whether they want to go forward or not, but those are negative factors that are going to keep them away from executing that pro-rata right. Remember, when an investor doesn’t execute their pro-rata right, it could send negative signals to the market because then other investors that are looking at putting money in your business are going to be like, “Hold on a second. This investor is an existing investor. They have the money to be able to reinvest. They’re not doing so. They’re not executing on their pro-rata right, so there’s
possibly something wrong with this business.” That’s why you always want to be careful with this because not executing that pro-rata right from one of your existing investors could put you literally in a very tough situation and perhaps even make your company go out of business if it runs out of money. Be very careful with those pro-rata rights. Can the pro-rata rights always be enforced? The question is really, yes, from a legal perspective, but no, from a practicality perspective because, in many instances, the founders actually persuade the investor from executing that pro-rata right because maybe there could be greater scenarios like a great investor coming in where they want to take a really big chunk of the business, and by the execution of that pro-rata right is not allowing for that investor to come in. You’ve seen great examples like Fred Wilson from Union Square Ventures. He’s
written several posts on this regard. And you’re going to see founders that are having those tough conversations with investors to help them understand why it doesn’t make sense for them to execute their pro-rata right. Obviously, it’s important to differentiate when there’s a potential positive outcome from not executing such pro-rata rights from a negative outcome. And that is whether there is already an existing investor lining up or not to make that investment and to give you that money. That is going to determine whether or not it makes sense to go forward with the execution of the pro-rata right.