Pro-rata rights: the good, the bad and the ugly

 Fred Wilson posted an article to explain the concept and value of pro-rata rights, with his usual elegance in making the concept clear.

Pro-rata rights are incredibly valuable for a simple reason: most startup companies fail, but pro-rata rights are your way to ensure that you can keep investing in the ones that make it.

Think of it another way: like a good trader (and contrary to human nature), you should cut your losses early and keep investing in your winners. The nature of the venture capital game, when played at a very early stage, is that one or two bets will generate most of your returns. When you see those (and I will address in a separate post the very imperfect ways in which you can try to identify winners early), then you should double down.

Ah, if only reality could be so readily pliable…

Investah Powa
What happens in most venture rounds for successful companies are the following three things:

  1. Everyone wants in
  2. The incoming investor will generally dictate how much is left over for existing investors
  3. The existing and new VC’s generally agree on the allocations with everyone else out of the room

To a large extent this reflects how the market works. Most angels will do a single shot investment and not be too bothered about re-investing, whilst the founders are trying to make their life easy and have fewer, more engaged investors to deal with.

The trouble of course is that, as an existing investor, you can end up with an absolutely measly allocation and get diluted no matter what you pro-rata rights are.

The only advice I can give to angels on this topic is (a) stay close to the company and add value (b) make it clear to the founder early that you are interested in considering reinvestment and be aware of the fundraising process and its timing (c) buy everyone drinks regularly and be a nice person.

Super Pro-Rata Games that can hurt you
Because pro-rata rights are indeed very valuable, there are more insidious ways in which people try to secure and monetize them.

Example1: Feed Me Your Children
The classic nasty right you are going to see in some seed term-sheets is a right to take say 50% of the next round of financing or a right to own say 20% of the company after your next round of financing. You will be told that the amazing VC who is investing in you does not want to spend all that quality time with you unless he is assured that he will be able to put enough money to work at the next round.

This is a bad practice for two simple reasons: it reduces your ability to shape the next round with full freedom of action and it has a potentially disastrous signaling effect (an investor has a contractual right to re-invest and does not do so).

Whatever lullaby VC’s might tell you about long-term commitment to your startup, we do seed investing for a reason, and that is to limit the amount of capital we commit at the outset until we are ready to commit more (duh). Valuation / dilution also has an impact but the fact is that the investor always has the option NOT to fund you.

There are many variations on this theme. I recently had a VC to whom I showed a seed opportunity tell me they were OK to come in but ONLY IF they could put 2X the same amount of money at the next round at a pre-determined price. I struggled to see how that would serve the best interests of the entrepreneur (or for that matter Atlas) and we left it there.  

Example 2: Feed Me Your Cousins
There are also VC’s who negotiate behind the scenes the transfer by the angels of their pro-rata rights to said VC. In this way, they reduce the initial risk but maximize the reinvestment option by stealth.   They may have some other arrangement with the angel (such as carry on outperformance). I really don’t like this because you’re getting a VC investor without knowing it.

Push your syndicate onto Angellist and make it all transparent.

The Way To Go
Whilst term-sheets have become incredibly transparent and very founder friendly over time, there are still aspects to negotiate and pro-rata rights are critical to understand well.  I have two recommendations:

  • 1.  As Fred Wilson says, you should give your investors pro-rata rights. They are a reward for backing you early.  They matter and they are fair.
  • 2.  You should never compromise on giving people any form of Super Pro-Rata Rights. Giving those away can seriously compromise your business.

The only way to get super pro-rata rights should be to earn your stripes in the field as an investor, work consistently with the company and get the founder to a place where “they simply cannot imagine life without you”.