The Pro-Rata Participation Right

fred
March 4th 2014

I’ve touched on this subject before. It is one the “three things you must have in a venture investment“.

The “pro-rata right” is the right to continue to participate in future rounds so that you can maintain your ownership. Let’s make it concrete with an example. You invest $50k in a seed round at a $5mm cap and own 1% of the company. The next round is a $3mm round at $9mm pre, $12mm post. If you don’t participate, you will be diluted 25% and will then own 0.75% of the company. On the other hand, if you buy 1% of the round, a $30k investment, you will continue to own 1% of the company. Your “pro-rata right” in this situation is a $30k allocation in the next round.

I think this is the single most important term anyone can negotiate for in a venture capital investment. The other two in the post I linked to above are the liquidation preference, which helps on the downside but not the upside, and the right to a board seat, which is important to some investors (USV is one of them) but not to all of them. The pro-rata right helps on the upside, which is where you make all of your money in venture deals, and should be important to all investors.

The pro-rata right is something that is not typically offered in a note with cap structure in seed deals. When The Gotham Gal started investing in these kind of deals we had a long talk about it. I was negative on notes and she was positive on them. She convinced me that notes with reasonable caps are OK, but I convinced her to negotiate for a pro-rata right. She gets that on all of her deals because she walks without it. And that is just one of the many reasons I love The Gotham Gal.

I was discussing a Series A round with some founders yesterday. We talked about what they should do with their seed investors. I encouraged them to offer the seed investors the right to participate in the round. I don’t know if their seed investors have the right or not. But regardless, I feel that the founders owe it to them because their seed investors were there for them before anyone else. It just feels like the right thing to do to me.

The meta point I have come to understand about early stage investing is that a small portion of your investments produce all of the returns. In those investments, you want to own as much as you can. It’s hard to own more than your initial stake, particularly as an angel investor. But it should not be hard to maintain your initial stake. You should reserve funds to do this, you should negotiate for a pro-rata right, and you should exercise your pro-rata right when you feel like the investment is doing well.