Respecting The Pro-Rata Right
When early stage investors make an equity (angel, seed, Srs A, Srs B) investment, they typically negotiate for something called a pro-rata right which gives them the right to maintain their ownership in the company by investing in future rounds on the same terms as new investors.
I have written about the pro-rata right a bunch here at AVC. I think it is one of the most important things that early stage investors get from their investments. Obviously the ownership an investor gets is the most important thing, but the ability to maintain it by making additional investments is also very valuable and can be the source of out-performance of an early stage portfolio (against whatever benchmark one might be using).
At USV, we value the pro-rata right and exercise it very frequently. We often will make five, six, or seven investments in a company between when we make our initial investment and when we make our final investment. We even have a follow-on fund called the Opportunity Fund, that allows us to take our pro-rata in companies that continue to raise privately and delay going public. Our Opportunity Fund will also make some investments in companies that aren’t currently in our portfolio. But a large part of our Opportunity Fund thesis is about maintaining ownership via our pro-rata rights.
In the last ten or so years, companies, lawyers, boards, management teams, founders, and in particular late stage investors have been disrespecting the pro-rata right by asking early stage VCs to cut back or waive their pro-rata rights in later stage financings. This can happen as early as Series B (and happens to angel and seed investors in Series A rounds), but it is even more common in the later stage rounds like Series C and beyond.
I think this is bad behavior as it disrepects the early and critical capital that angels, seed investors, and early stage VCs put into the business to allow it to get to where it is. If the company agrees to a pro-rata right in an early round, it really ought to commit to live up to that bargain. But increasingly nobody does that and it is a black mark on the sector in my view. We make commitments knowing that we don’t plan on living up to them. It is very unfortunate.
The reason this happens is that allocations get tight in later stage rounds, particularly where the company is doing well and everyone wants to get into the round. The new investors, including the investor that is leading the round, will almost always have a minimum amount of ownership they want to get to in the round and the math tends to work out that the only way to get there is to cut back the early investor’s pro-rata rights.
Sometimes the way the gap is filled is by creating secondary for founders, early employees, and early investors. That can work and is sometimes good for everyone involved. That “trick” has been the saving grace on this issue over the last few years.
But I believe we are at a crossroads on this issue and I am wondering if early stage investors need to put more teeth into our pro-rata rights to insure they are honored. What if a company that was unable to offer a full pro-rata right to an early stage investor in a later round was forced to go back and change the price of an earlier round to make it up to the early stage investor? Or what if an early stage investor got warrants at the new round price to make up for an inability to honor the pro-rata right?
These are just two suggestions I came up with in a few seconds of thinking about it. But I would really like to force early stage companies, their lawyers, and their boards to think clearly and carefully about the pro-rata right when granting it. The current practice seems like “we can give this because we always get away with not honoring it down the road” and frankly that sucks.
I’ve talked to a lot of founders about this issue, and feel your representation is a little one-sided. When early stage investors invest, they are frequently not only promising money, but help in various forms. Being an active board member, access to your network for recruiting and partnerships, strategy advice, etc. And that is part of why founders accept the money from one early stage investor over another.When these later stage investors need a certain level of ownership and need to eat into pro-rata rights to get it, what these founders frequently ask is what earlier stage investors didn’t live up to their end of the bargain. And the answer frequently is most of them. They put in money and want their pro-rata when the company raises again, but did essentially not much to help the company in between. And it’s not like they were willing to lead the round before this new investor came in. So for founders, it’s easy to sacrifice those relationships. For earlier stage investors that actually helped, I find founders are willing to make sure they get the pro-rata. Because they want to keep receiving the help and reward good investors to them.
A$$hole$ abound in finance. Up & down the food chain.
Reading the comments here, it seems to be more an relationship issuebetween earlier and later stage investors than between founders and investors.Also, regarding liquidation preferencesInteresting topic because laymen would assume that everybodygets diluted and if you explain them you have to make some additional statements:It’s a negotiated right, so it can be re-negotiated. Agree, overridingit just because it’s unpleasant is in no way the manner of an honorablemerchant (as long as the investor is behaving in the company’s interest as well)I’d argue if the early capital is critical and interests needto be protected, so is the founders ongoing contribution: Therefore whileinvestors negotiate for a continuous **STAKE** in the company, founders should atthe same time negotiate for a continuous **SAY** in the company.I’d even argue it’s the interest of both sides: I would notwant to venture out and explore new worlds when I’d know that my Columbus isnot in charge but the Spanish king. And I as Spanish king would want them tocome back with at least a little gold and not lose them to a paradise island…
Sadly, as startups progress into the mid-to-later stages of financing, some of them quickly forget the early investors and angels that gave them their first checks, as they get muscled with more aggressive late stage investors.Angel investors in particular are often excluded from pro-rata rights in favor of “major” investors who have it. As an angel, I try to get a side letter, or get it in writing that the CEO will honor my choice of pro-rata follow-ups, although it can get “expensive” in later rounds. In some cases, the relationship you have with the company will allow you to be included, even if you don’t have contractual rights to it. Exceptions are made if the CEO wants to, typically. These exceptions are easier when the amounts are smaller.
Relying on non contractual obligations is honestly, kinda praying as a strategy.
Maybe you misunderstood. What I was saying is that angels are sometimes excluded from pro-rata by design, but can get it if they have a good relationship with the CEO (speaking from experience).
Must have.Usually a careful reader.
If they want you out, they’ll price you out, right?
No, they can create all kinds of terms and actions that create havoc with you. For example, the angel org I helped start doesn’t know where it sits on the cap table in a lot of cases, nor does it have data on waterfalls. Just not a major enough investor
No, price is the same for all participants in a given round.
Thinking more of artificial valuation increase that makes the raw cash outlay too expensive for you.
What about up stream investors, angels and friends/family? Do you have the same position with respect to pro-rata?
Why not let the LPs of the first round invest directly at later rounds? It feels like the 2/20 is double charging ? And it would allow for highe post-money for the entrepreneurs?
USV not a charity?LP didn’t find the deal.
The deal is already found and USV got paid for round one. It’s like buying a house for X and paying a commision, adding a second floor and mailing the same agent another check for 06% of the increase in its appraisal .
Isn’t it more like someone gives you the money to build the house & then says they would like to invest when you upgrade it? They make part of that initial investment?
Unfortunately many founders “forget” how important the early stage investors to them and the risk they took. I’d also add the problem with liquidation preference waterfall, which does not seem to be fair too.
I think that the “pro-rata” rights should be detachable. In other words, let the early stage investor either exercise or if need be sell those detachable rights, not unlike detachable warrants. This way the economic value of the pro-rata rights is maintained but value is transferred if the ne investor needs more.
Still a cost to the company,
It’s one that they already bear. Nothing incremental
But, when they ask you not to exercise it, they don’t beat it which is the point?
If/when a founder asks the investor not to exercise, the founder is either asking for a retrade of pas negotiation or economic value right then
Gotta have “Up, down, and WTF is going on” – a wise VC (@Feld?)
Great archival pull Teddy.
Are they invoking a legal way of reneging or just the pressure of “if you don’t relent we won’t be able to close this/further investment rounds”. If it’s ‘just’ pressure is there data on what happens if an investor holds firm and says no. These rights are valuable to me. They are the compensation I get for backing you when you were nothing. The mere act of asking me to waive them is a stain on your character.
People that don’t value their own handshakes are worthless in my world.If you are building a team those are the people you don’t want.
So if it’s a choice between closing the round (without pro rata) or closing the company (with pro rata), which handshake are you referring to?
If you won’t honor or help honor the pro rata rights, then there is no reason to accept them in the term sheet. If your next investors want to screw your angels, what guarantee do you have they will not do the same to you later?Just say NO.
Am i missing something, or is a pro-rata right not included as part of a legally binding contract of investment between investor and founder at USV? I’d like to see one of your ‘model’ term sheets.”I’ll take the early stage risk and you take the later stage reward” – very generous.
The problem is that the defendant is your bread and butter and your reputation as a VC is shattered.
Not if you think of your market as LPs & that 99% of entrepreneurs have a startup career that is 1 entity long.Most a$$hole$ live in highly transactional high turnover of participant environments.Like VC.How do you think Fred got 50,000 MAU?
Perhaps, but not all founders are cut from the same cloth. Being unwilling to enforce terms creates another kind of reputation, one to be exploited by the unscrupulous entrepreneur. Word gets around.
The problem with contracts is the costs associated with enforcing them.In UK / Canada & other jurisdictions, the concept of costs solves a lot of dishonourable behaviour.
Sometimes the means of not honoring the pro-rata is a “feature” where pro-rata rights are waived by a majority of investors holding the right. Company counsel usually wants to extinguish the pro-rata right as quickly as possible to move forward with the deal. Waiver by majority consent among a class or among all pro-rata rights holders is an easy way to do that and this “feature” gets put in the initial docs. Later the largest investors waive the pro rata rights on behalf of the investor group (including small investors) but then negotiate to take part of the new deal for themselves which is a huge conflict of interest and really leaves a bad taste in my mouth.I think some solutions are:1. No waiving pro-rata rights on behalf of other rights holders (or at a very minimum investors participating in the round cannot waive pro-rata rights on behalf of non-participating investors).2. Tight timelines for making pro-rata investment decisions. Companies need to move on and not wait for decisions from pro-rata rights holders (or have early investors waiting around to preserve optionality) and timelines to decide should be short (~10 days).
Food Chain Issue.
Had that happen to me as an angel several times. Some companies offer to buy you out of the cap table on a Series A, B, or C funding. Sometimes I have taken it, sometimes I haven’t. It really sucks as an angel, because finding a winner is so hard you want to press your winners and the company/lawyers/vc’s don’t let you.I am okay with “pay to play” rounds.As a seed fund, we carve out pro-rata in every deal and pass them along to our LPs for no cost at Series B or later. Of course, as GP’s, we can invest our own money in those rounds as well.Often, we run into companies that have done an early round, and this is their first institutional round. We counsel the entrepreneurs to make room for the early investors if they want it. We communicate clearly to them, and we will even share diligence with them. I am especially sensitive to their plight.It seems like pro-rata is an intangible asset, but I certainly haven’t heard of anyone buying it. I know of “buy out” funds that try and build relationships with angel groups and funds like ours but usually their terms aren’t very good, and they only want your Uber’s. They don’t want companies that are going to pay 2x-4x. So, they don’t want to take any risk……as an investor I get paid to take risk.
The Gotham Gal always insists on pro rata and evidently always gets it, according to a previous post here on AVC.I had a conversation asking her how, and she suggested having a side note between you and the company. I think @william also suggests this in these comments too.
There are quite a few thoughtful and reasoned questions/prospective remedies to this issue.I’m not sure if or how my suggestion adds to the discussion, but in the event that pro-rata rights are severed or altered in ways deleterious to an investor, perhaps both parties could establish some form of revenue-share agreement.That agreement would serve as a close proxy (not less than 70%) of the expected opportunity cost of forfeiting one’s pro-rata rights.Of course, there would be a number of assumptions involved, for the value of the agreement would largely turn on said investor’s future, expected ownership in the company BUT FOR the removal of his/her pro-rata rights.Perhaps the agreement would yield a lump sum (balloon payment) at a future date. Perhaps, instead, there would be steady, incremental payments that, in total, would match the value that was arguably lost.
What sucks is being a not-quite-early-enough employee and having to watch those secondaries…culminating with an IPO lockup waiver offering (open to sr execs & investors only) followed by a stock price crash. Sound familiar? It should…
Early stage pro-rata rights can be valued like an option, and should be tradable for another asset with similar tangible value. Perhaps later stage investors should offer a formulaically equitable promote on their new $ to those early stage investors who have been cut back.
Fred, I think whats happening is a reflection of modern world. Literally, modernity doesn’t have as much integrity. Trump, social media is creating new norms and ultimately new people. We feel that it is okay to bend the rules more than ever.The thing is that there isn’t anymore equity to give in a lot of cases. Buying from the founders is probably the best we can do.Another approach is to pre-emptively buy up in bridge rounds and double down before other investors show up.It would be interesting if you could experiment with that with the opportunity fund — although it might substantially change the risk profile on that vehicle.
I agree if pro rata is included, it should be granted.But I fervently disagree with the notion that investors are entitled to pro rata from the get go.
Has anyone considered Mark Suster’s approach to this problem? https://bothsidesofthetable…Essentially, what Mark wrote is that to address pro rata rights head-on, he prefers to include a clause that a majority of preferred stock class votes to waive pro rata rights, in whole or in part, but rights must be waived or exercised in proportion to each pro rata holder.As Mark puts it:”…I’ve started guaranteeing angels pro rata rights regardless of their check size. But I’ve started putting in a clause that the majority of our class of preferred shares can vote to waive these rights entirely or in part. And to the extent that I waive my rights (if we constitute a majority) then everybody in the round must waive their rights. That is the most founder friends AND angel friendly way of doing it that I have found.BUT. And there’s always a but.I also include a clause that to the extent that the majority does take part of its prorata it must offer the same to angels who have participated in that round in the exact same proportion as the majority takes. So if I as 80% of a round work with the CEO and determine that it makes sense for us to only take 40% of our prorata to make room for a new, important, investor and not overly dilute management then I can require all people in my round to do so. But I can’t secretly take 50% while offering angels 0%. That seems fair. We are all bound to the same economics.”Now, this doesn’t solve for the issue if the founder does not respect the pro rata rights, but my educated guess is that if you asked the founders why they are not honoring the earlier rights, it’s probably because funding would be tied up without them. But if there is a compromising solution, this seems like a good way to bring about alignment for everyone. And of course, this would not prevent asking for something in return for the portion of the pro rata right that was not exercised – perhaps by further guaranteeing the next round’s pro rata right, or having some of those rights taken up through a secondary offering to earlier investors, employees, or founders.
Initial dollars are not charity – they are an investment in a business (not a founder). I can see many situations where the Pro-Rata need not be honored, change in business model to a lower risk venture, different exits strategies etc.
Values when lived always have a price tag attached. Values without a price tag are words.
Fraud in the inducement negates any contract. Also, is there really any consideration? If an early stage VC wants this, write up a seperare contact and pay for the option with dollars (not promises of what excellent advise you’ll give).
Meh, I have seen people justify any behavior to get what they want. Yes, there should be honor but you will see what it really means when things get squeezed, or things get really tough.
I think the whole point is that, in most cases, it is being negotiated at the point of the later/larger raise (i.e. for us to close this round, we really need you to waive your pro-rata rights).One of the other challenges with pro-rata is that, from the founders side of the table, you never really know how much you’re going to need to go out and raise (and nailing down those commitments throughout the raise can be frustrating)…if everyone exercises their pro-rata, then are we 1/2 way to done on this round? How much does the lead need? How much do we need to fill after the lead and pro-rata is figured out?All small things in the big picture…but absolutely things that need to get figured out throughout the process.
You forgot the part of the story where you applied an unstated leverage upon your partner.Come on, can’t skip the action sequences.
I don’t see it as putting it on the back of the first investors. It’s just another negotiating thing (especially if/when they can’t lead the next round).Honestly, I think it’s almost always the new lead that is asking/requiring that the pro-rata rights agree to be waived…though maybe I’m wrong about that.Sometimes, you also want/need to get new players into a round for strategic reasons…and if the round is not too large, pro-rata can throw a wrench into that too….but where I do agree is that these are all “self inflicted” problems (and really if you are negotiating over pro-rata you are probably in a “good problems” kind of world).Sometimes early investors don’t get to double (or triple) down on their better bets…it’s a “professional investor” problem…which honestly, in the list of things to be concerned about, does not *really* register that high to most founders I know.
Are you suggesting contracts can not and should not be renegotiated?
Even better story.
I like the fraud approach as it clear you do not want the performance at this point.