Pro Rata Rights

Published on :

21 Aug, 2024

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Pro rata rights refer to the rights and not an obligation to maintain the original level of ownership percentage in subsequent financing rounds. It can be a powerful tool for startup founders as they can utilize it to secure the first round of debt or equity funding.

Some investors often do not invest their funds unless they receive the rights. Early-stage organizations may decide to grant such rights to only specific investors, trying to incentivize them. That said, late-stage companies generally award such rights to major investors. Remember that companies can raise funds from investors with such rights and existing or new investors not possessing these rights.

What Are Pro Rata Rights?

Pro rata rights refer to a right that a company gives investors, enabling them to maintain their original ownership percentage level during the next funding rounds. It makes raising capital in the first funding round easier for a startup.
A noteworthy advantage of such rights is that they enable shareholders to maintain their voting power and ownership percentage in a company.
Investors not having more funds to invest and concerns related to the growth prospects of a company can lead to waiver of pro rata rights.
Investors may negotiate with startups to get such rights.

How Does Pro Rata Rights Work?

Pro rata rights in Venture Capital refer to an agreement between a company and an investor whereby the former gives the latter the right to participate in more funding rounds. That said, the investor does not have an obligation to participate in any subsequent funding round. These rights guarantee investors' allocation if they desire to invest funds.

In essence, the pro rata rights agreement concept is related to the idea of dilution. Every new equity financing round implies a fresh issue of shares. Following the issuance of new shares, the dilution of the current shareholders’ equity stake percentage occurs. Simply put, the company’s current shareholders lose some voting power. This portion is calculated in percentage.

To steer clear of this kind of situation, investors may ask companies to include a provision granting the former pro rata rights. An investor with such rights can then maintain their voting power and ownership percentage even with the fresh issuance of shares.

As noted above, these rights holders can exercise them at their discretion. Some investors may decide not to exercise the option to invest their funds in the next financing rounds. Some common reasons why an investor may not opt to allocate their funds are as follows:

Unsatisfactory development of the organization
Poor performance developed by the company
Substantial investments are required to maintain the original ownership percentage

How To Calculate Pro Rata?

One can utilize the following formula to compute pro rata:

Pro Rata Distribution = Pro Rata Share x The Total Quantity Of the Related Items

Individuals must follow these steps to ensure they use the above formula effectively:

Accumulate The Required Data

This step involves collecting necessary information, which includes the total number of ‘true’ items, the maximum quantity of those items, and the overall quantity of the related items.

Compute The Pro Rata Share

Individuals must multiply the total number of ‘true’ items by the total items’ maximum quantity to calculate pro rata share.

Compute Pro Rata Distribution

Computing the pro rata distribution involves multiplying the pro rata share calculated in the previous step by the overall quantity of the related items.

Alternatively, one may divide the overall quantity of related items by the total items’ maximum quantity and then multiply the result by the ‘true’ number to compute pro rata distribution.

Examples

Let us look at a few pro rata right examples to understand the concept better.

Example #1

Suppose David is an angel investor who invested in Company XYZ, an AI or artificial intelligence startup. In the seed funding round, he invested $100,000 at a market capitalization of $5 million. As a result, he owned 2% of XYZ. When negotiating, the organization granted David pro rata rights in the funding round.

The company delivered a stellar performance for the next two years and eventually raised Series A funding. In the Series A round, Company XYZ had a pre-money valuation of $7.5 million and a post-money valuation of $10 million. David decided to exercise his pro rata rights in the funding round. So, he had to invest $200,000 more to maintain his 2% equity ownership.

Example #2

In June 2023, Boadicea Resources Ltd. launched a pro rata rights issue, enticing shareholders to purchase three shares for every five already held by them. This would enable the company to raise funds worth A$2.4 million.

Thus, investors are now able to purchase new shares at A$0.05. Moreover, for every couple of equity shares they subscribe to, they will get a free-attaching option that they can exercise at A$0.10 prior to January 30, 2026.

How To Obtain?

Typically, investors negotiate with companies for such rights. Seed and angel investors often add a pro rata clause when signing the agreement for multiple reasons, such as the following:

Adding the clause can ensure they can invest in the next funding rounds. For example, a Series B or C.
It can also ensure they maintain a specific ownership percentage necessary to have a seat on the company’s board. However, this is not always applicable.

When To Waive?

The waiver of pro rata rights may occur for multiple reasons. Some of them are as follows:

Investors may not have additional funds to invest.
An investor could have concerns regarding the company’s growth prospects.
Investors may not mind the equity dilution.

One must note that relinquishing such rights does not always lead to unfavorable financial outcomes, even when investors think a startup will surely achieve unicorn status. Letting go of the rights allows more powerful investors to get a seat on the board. This can catapult a startup to new heights that were impossible to reach otherwise.

Pros And Cons

Let us discuss the benefits and limitations of pro rata rights agreements.

#1 - Pros

Such rights reward early investors for taking the risk of investing in a company in the early stages.
These rights incentivize the early investors to allocate funds again in subsequent funding rounds.
Inserting a pro rata clause allows shareholders to prevent the dilution of their current equity ownership. Moreover, this enables them to maintain their voting power.

#2 - Cons

A pro rata clause may lead to conflicts as the early investors with such rights might do everything possible to keep the rights.
Granting such rights to investors may make raising additional capital difficult for a startup. New investors might not be willing to allocate funds to an organization in which several existing shareholders have the right to invest in funding rounds to maintain their ownership percentage.

Frequently Asked Questions (FAQs)

1. What are pro rata rights vs. preemptive rights?

Pro rata rights allow investors the opportunity to remain in control of the investment made by them, while preemptive rights provide investors with an additional layer of protection. That said, investors do not have an obligation to exercise any of these rights.

2. What does a pro rata rights offer of 1:5 give existing shareholders?

A pro rata rights offer of 1:5 provides shareholders of a company with the right to buy a new equity share for every five shares they hold in their portfolio.

3. What document are pro rata rights in?

Such rights in a side letter or a term sheet guarantee investors the opportunity to allocate funds in subsequent rounds of funding to maintain their ownership percentage in a company.

4. How do pro rata rights work in a SAFE?

These rights refer to the rights that SAFE or Simple Agreement For Future Equity investors have to buy more shares in a company if it raises more money in the next funding rounds. Investors can only exercise such rights after the conversion of the SAFE into the organization’s preferred shares.