When you invest in an early-stage startup, you will often receive “pro rata rights.” This means you have the right to invest in future fundraising rounds.
Pro rata rights are extremely important. They give you the option to invest in each subsequent fundraising round to avoid dilution (if you need a clear explanation of how dilution works, click here).
Fred Wilson, one of my favorite venture capitalists (VCs), explained pro rata on his excellent blog, AVC, back in 2014.
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.
Pro rata rights are important because when you invest in a startup that really takes off, it’s likely that competition to invest will become intense. With pro rata rights, you’re entitled to invest an amount that allows you to maintain the same ownership percentage.
This allows you to essentially double down on your winners. And that’s a powerful tool.
In a new blog post this week titled “The Long Buy,” Wilson expanded on the importance of pro rata. Here’s an excerpt…
One of the many things that venture capital has taught me is the value of the long buy.
What I mean by a “long buy” is buying shares in a company over a long period of time. We have investments where we have bought shares seven or eight times over a ten to twelve year period.
There are a bunch of reasons why a long buy is so attractive:
- You get to learn more about the opportunity before committing significant funds and each and every subsequent investment is based on a better understanding of the business, the team, the market, the product, etc.
- You get to build a blended purchase price which is less dependent on the circumstances of a particular moment in time.
- There is often a moment, sometimes several, over the course of a long buy when the company or its market is out of favor, and you can aggressively step up your purchase on more attractive terms than were possible in the first few purchases.
The entire post is well worth a read (and AVC is a great place to learn about early-stage investing).
I’ve been investing in startups online for more than five years. And I’ve come to appreciate the importance of pro rata more and more. At first, I rarely took advantage of the option, believing it was better to invest in new opportunities.
But as I became more experienced, I learned that when you’ve got a potentially big winner, it’s better to double down rather than find a new opportunity. I now take advantage of pro rata rights at least 35% of the time. And that number keeps going up.
AngelList makes it easy to take advantage of pro rata rights. As a previous investor, you get priority. And you’ll almost always be able to invest enough to maintain your ownership percentage. Sometimes you will even have the option to take “super pro rata” and invest more than necessary to keep your ownership percentage the same.
Note: Not all deals include pro rata rights. And sometimes even when they do, you may not get the chance to invest. This is ultimately up to the founders. And if new VCs are coming into the deal, they will occasionally wipe out previous investors’ pro rata rights. I’ve seen this happen only a handful of times, however. The vast majority of the time, previous investors’ pro rata rights are respected.