Pro Rata Rights: Protecting Your Equity in Startups

Is it appropriate to grant investors pro-rata rights? If so, how do you determine what those rights should be? There are always brand new VC firms providing seed funding to entrepreneurs. Some of them want to keep or even enhance their position in these companies by investing in succeeding investment rounds as the companies develop and expand their operations. Investors like being thought of favorably when your company expands and seeks further funding.

Not all situations can be resolved with a generic “Thank you” note. When investing in a company, early shareholders often want the guarantee that they may keep their share even if the business succeeds. Having pro-rata rights may be useful in this regard. But what are the terms of negotiating pro rata rights? How do you know if there are any benefits of pro rata rights? Let’s understand them in detail, possibly with an example of pro rata rights in this article.

Pro rata rights in startups

Fund managers have the option to participate in a company’s following funding round(s) if they are granted pro-rata rights. They might avoid having their initial investment amount (their “stake”) in a firm be reduced (a phenomenon known as “dilution“) by taking part in future funding rounds. While dilution isn’t always a bad thing, investors should be wary of it if any of the following apply:

• They anticipate future success for the firm and reason that more stakes will provide higher dividends.
• They would want to maintain rights that are tied to their ownership percentages, such as board representation, access to company information, and voting privileges.

This section will define pro-rata rights, discuss how they are exercised, and highlight their importance to investors.

What Are Pro Rata Rights?

Investors may be granted the “pro-rata right” in a legal sense to keep their original proportion of ownership in the firm through successive rounds of funding; however, this is not a duty on the part of the company. This means that an investor who has a pro-rata right who first invested 10% in a firm has the opportunity to spend an additional 10% in subsequent fundraising rounds. The phrase “pro-rata right” is often used in the context of venture capital funding.

How do pro-rata rights work?

An investor may negotiate pro-rata rights with a corporation, which gives the investor the option but not the need to take part in a subsequent fundraising round.

These rights are frequently granted by companies to some but not all investors. Some will only invest if they are guaranteed pro-rata rights, while others are willing to take a chance without this guarantee.

To reward those who have been very beneficial to them, startups may give them pro-rata rights. “Major investors” (those who have provided a substantial share of the company’s total finance) often get pro-rata rights in later-stage businesses.

A company may seek funding from either current or prospective investors who have no pro-rata rights, or from investors who do have pro-rata rights. The only purpose of pro-rata rights is to ensure an investor receives an allocation, should they want to invest.

Examples of pro rata rights in practice

Here’s a sample of what this may look like to help clarify the procedure:

• A seed round investor puts $1,000 into your firm at a maximum value of $100,000. If an investor puts in $1,000, they will own 1% of your company.
• The next investment round for your business brings in $200,000.
• If the investor chooses not to take part in the fundraising round, their stake in your company will decrease to less than 1%.
• The investor’s 1% ownership interest would be maintained if they contributed $2,000 (1% of the following round’s funding) following their pro rata rights.

Benefits of Pro Rata Rights for Startup Investors

Investors in subsequent rounds of investment, especially major investors who commit substantial capital to take the firm to the “next level” of development and operations, may also be offered pro-rata rights as an incentive. Founders who are looking for liquidity may be able to sell some of their stake in the company to the investors who they believe will remain involved in the company’s development if they are granted certain rights. This could be beneficial for both the startup and the investors.

Why pro-rata rights are important for protecting equity

Investors like pro-rata rights because they ensure they may maintain ownership in successful firms. It is crucial to keep in mind that not all investments end up being lucrative. It’s certain that some of the firms that get funding will fail, that others will perform well enough for the VCs to recoup their initial investment, and that a small percentage will become exceptional success stories, maybe even unicorns.

Profit for venture capitalists comes from holding onto ownership stakes in companies that go on to achieve significant success. Early investors are rewarded with pro-rata rights since they took a risk by investing in the firm during its most precarious years.

If the firm is doing well and wants to seek more money, the early investors will want to make sure that their stake isn’t diluted in any way. For investors, pro rata rights are crucial since they may determine whether they make hundreds or millions on a given investment.

Disadvantages of pro-rata rights

The advantages concerning pro-rata rights should not be overlooked, but neither should the potential risks. Startups that want to raise money in many rounds should give careful consideration to which investors will acquire these rights since giving too high a share to current investors might be counterproductive when seeking out new sources of funding.

Pro-rata rights, meanwhile, do not ensure new investment from current investors. When the Company’s future estimates are slim or unclear, investors may be reluctant to use their pro rata rights. Successfully negotiating a round of fundraising with an investor is no assurance that the investor will participate in subsequent equity rounds, and founders should keep this in mind.

Important regulatory considerations for pro rata rights

A corporation that offers shares employing pro-rata rights may need to submit an SEC disclosure statement or face state law limitations. Shareholders should also sign rights agreements outlining their responsibilities. Consider these regulatory issues while setting up pro-rata rights.

• Federal legislation – The SEC governs securities sales in the US. Companies cannot issue securities without SEC registration or other obligations under these laws. Firms must disclose pro-rata rights in their annual reports and registration statements.
• State legislation – Many states also regulate securities issuance. These laws may restrict pro-rata rights use or require different disclosures. A corporation should contact an attorney before issuing securities with pro-rata rights.
• SEC guidelines – Pro-rata rights in securities offerings are governed by SEC laws. SEC Rule 701(c) covers these. In an SEC-filed offering statement, issuers must disclose each shareholder’s share percentage under Rule 701(c).
• Pro-rata rights Obligations – Each shareholder should sign a pro-rata rights agreement when issuing securities. The agreement should detail how a shareholder’s stake in the company affects their voting power and how pro-rata rights are distributed among the various share classes.

How to calculate pro-rata rights

The formula for calculating pro-rata takes into account the following three factors:

• The number of true, owned, or incurred goods
• The maximum allowable quantity
• Associated item’s quantity

How pro-rata rights are typically structured in investment agreements

To guarantee that investors are paid properly and get an ownership stake in the firm that is commensurate with their initial investment, pro rata rights are essential in a startup.

Investors in a new company have a few options for how to organize their pro rata rights. The most frequent method is to give all investors the same percentage of ownership in the firm regardless of the amount they put in. The term “one-time” pro-rata right describes this form of agreement.

Pro-rata rights may also be structured such that investors earn a certain percentage of the company’s stock depending on the amount they contributed over a certain period (often six months or a year). A “recurring” pro-rata right describes this kind of contract.

A third option to establish pro-rata rights involves distributing shares to investors in proportion to the amount they contributed over a certain period, with adjustments made for any rise or fall in the company’s value. A “sliding” pro-rata right describes this sort of arrangement.

Negotiating Pro Rata Rights

Investors’ interests may be safeguarded via the negotiation of pro-rata rights, which is an integral aspect of venture capital. Investors should know their present ownership percentage and the conditions of the agreement before negotiating these rights. Considerations like firm value and number of funding rounds are also important. Pro-rata rights do not come guaranteed and must be established in each situation. Before committing funds, investors should consult with the company and any other parties involved in the investment.

Factors to consider when negotiating pro-rata rights

There are several elements to think about while negotiating pro-rata rights. By exercising their pro rata rights, or preemptive rights, existing shareholders may ensure that their percentage of ownership in the firm remains unchanged. The following are some important considerations to use in your negotiations:

• To keep ownership rights in balance with one another, one must first establish a target ownership rate.
• The market value of the firm is the most important factor in determining the price of the shares being issued. Existing shareholders should negotiate anti-dilution protection to prevent their stake from being diluted too much.
• To provide shareholders with a fair chance to exercise their rights, it is crucial to establish reasonable schedules and deadlines. If you want to make smart choices, you need access to relevant information.
• Another important factor is the discussion of pro-rata rights transferability, including any restrictions or criteria. There has to be an evaluation of voting rights and how that influences decision-making.
• In addition to pro-rata rights, investigating potential co-investment alternatives is a must. Compliance with the law and applicable regulations requires careful thought and planning.
• To successfully negotiate pro-rata rights, it is suggested that you consult with legal and financial professionals.

What startup founders may be willing to offer in exchange for pro rata rights?

Considering everything we’ve covered, it’s easy to see why pro-rata rights are best for the investor. There is a significant gap in return on investment between investors with and without pro-rata rights. But why would a startup want to give up any of its equity in exchange for pro rata rights?

Startups that are sceptical of their growth potential may do well to ensure that their first investors remain on board. But why even give early contributors pro-rata rights if the startup is doing well and doesn’t seem to have any trouble identifying new investors for subsequent rounds?

Being transparent and responsive with your investors is essentially all that can be recommended. Because of the complexity of the founder-investor dynamic, both parties need to be comfortable with having tough conversations and maintaining open lines of communication. In the end, creators and investors alike want what’s best for the business.

The impact of pro rata rights on future investment opportunities

Existing investors are guaranteed the ability to engage in future fundraising initiatives with pro-rata participation rights, often known as pro-rata investment rights. With pro-rata participation rights, private investors may keep and even increase their stake in a company by taking part in subsequent investment rounds. Therefore, the rights provide private investors with a measure of security against the threat of a loss of control as a result of an influx of new investors.

Manage your startup equity with Eqvista!

Your priority as a founder may not be to figure out the ins and outs of financing. It’s probably not even close to what you had in mind when you originally chose to launch your business. However, it is still important to know the assets you own and the way it is distributed in your cap table by studying how equity gets distributed and diluted. We at Eqvista, are happy to assist you in further exploring the potential effects of pro rata rights on your company’s cap table. Contact us immediately to discuss our innovative cap table service.