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What is pro rata and why does it matter when investing in startups?

What is pro rata?

For a so-called dead language, Latin still manages to pop up frequently in the modern day, especially in the legal and financial world. The term “pro rata” is Latin, and it is simply a fancy way to say, “in proportion”.

Pro rata is the benefit you receive from something that you do or something you own will be in proportion to your share of the whole. For example, if you work part-time four days per week, then your salary would be paid on a pro rata basis of 80% of the full-time wage. Or, if you own 5% of a company and that company paid a dividend totaling $100,000, then your dividend would be paid on a pro rata basis of 5% x $100,000 = $5,000.

What are pro rata investment rights?

Pro rata investment rights give an investor the right (but not the obligation) to invest in future funding rounds, so they can maintain their percentage ownership of the company.

A pro rata investment right gives an investor the opportunity to prevent  their ownership from being  diluted when new investments are made.

Dilution of shareholding 

It is important to understand the concept of dilution because this can have  a major impact on your ownership stake. A shareholder owns a portion of a company based on how many shares they own compared to the total number of issued shares. But as additional funding rounds occur, more shares may be issued and if the shareholder does not continue to purchase more shares, then their percentage of ownership will be diluted. 

For example, if a startup issued 10m shares and a seed investor purchased 2m shares, they would own 20% of the company. But if an additional 10m shares were issued by the company in future capital raises, and the seed investor did not buy any more shares, then their percentage ownership of the company would be diluted and would drop down to 10% (their original 2m shares out of the new total of 20m shares).

Check out this post if you’d like to learn more about dilution.

Why is pro rata important?

Pro rata investment rights are important because of the nature of Venture Capital (VC) and how investors potentially make their returns. The unfortunate reality in startup investing is that many companies fail, and many investors lose all of the money invested. . So, the way to potentially achieve good returns in VC is to double down on the successful companies, through your pro rata rights.

The big VC investors are the ones who usually receive pro rata rights. So, if one of their companies is doing well, they will continue to invest and stay in for subsequent funding rounds. 

Platforms like Propel(x) work hard to secure pro-rata rights for our investors. If you have invested in a syndicate via Propel(x), please look out for portfolio updates from Propel(x) and be on the watch for these opportunities – such opportunities are often filled out rapidly.

Pro rata example

Let us work through a hypothetical example to illustrate how pro rata investment rights can potentially work in a startup investment scenario. Let us say there were two seed investors; one with experience who negotiated hard and successfully got pro rata rights into her term sheet, and the other a novice whose term sheet did not include pro rata rights. And let us say this startup knocks it out of the park with multiple funding rounds and a highly profitable exit. To keep it simple and illustrate the point, we will assume that none of the new investors in subsequent funding rounds have pro rata rights, so that we can really see the difference that pro rata rights can make.

This table is for illustrative purposes only and does imply or guarantee any type of future return. 

How pro rata works in venture capital deals

The above example illustrates the principle of how pro rata works in VC deals. An investor with pro rata investment rights can continue to invest in subsequent funding rounds to maintain their percentage ownership and potentially maximize their returns on a good investment in a company that is doing well.

It is essential to understand that pro rata is favorable for an investor because it provides significant advantages to extend your upside, as shown in the above example. Because  it is favorable, it is usually not offered to all investors – instead it is generally reserved to attract serious investors who can bring significant money, experience, or contacts to the table, or all three. 

Small investors generally would not be given pro rata rights when they invest. But the rise of angel investing platforms such as Propel(x) and with the use of a Special Purpose Vehicle (SPV) enabling individual investors to band together and invest as a group (syndicate) means the negotiation of pro rata rights for small investors can be  a possibility. At Propel(x), we work hard to secure pro-rata rights for our syndicate investors. Many of our investors have benefited from having access to subsequent rounds via our syndicate pro-rata rights.

Pro rata rights definitely have their advantages, however, it is important to remember that they are not a free ride. If you do decide to maintain your ownership stake as an investor, you still need to put your money on the table and invest in the subsequent funding rounds. As shown in the example above, while Seed Investor B with the pro rata rights did generate a total return of $4.3m more than Seed Investor A, she did have to invest an extra $4.4m to generate that greater return.

For founders considering offering pro rata rights, it is important to consider the issue of control. If founders offer pro rata rights too freely, it is possible that a single large investor, or a small group of investors, could build their ownership stake significantly through progressive funding rounds and  they could effectively take control of the company because the founders have been so diluted.

When it comes to VC deals, remember that nothing is set in stone. Things can change, especially when a big investor is offering the incentive of a major capital injection. Experienced VCs know what deal terms can make the difference between a failure, a moderate exit, and a startup unicorn.  They may insist on changing the terms of existing investments before they will make a big capital injection – and this might include removal of pro rata rights for existing investors. So, remember that if you are holding pro rata rights from an early round, there is a chance they might get negotiated out in a subsequent round.

Check out this link to find out more about becoming an angel investor.

READ MORE:  Propel(x) has been nominated for “Best Alternative Investments Platform” for the 2021 Benzinga Global Fintech Awards!

How is pro rata follow-on calculated?

The term follow-on investment is sometimes used in relation to pro rata rights. It simply means that an existing investor “follows on” (continues) by making a further investment in a later stage funding round. 

It is quite straightforward to calculate how much an existing investor with pro rata rights needs to invest in order to maintain their shareholding percentage – just multiply their percentage ownership before the funding round by the total number of new shares being issued and then by the share price. For example, if an existing investor with pro rata rights holds 25% of the total issued shares, and 4m shares are issued at $1.00 each in a new funding round, then the existing investor would need to invest 25% x 4m x $1.00 = $1m in the new round. This would maintain their ownership percentage at the same 25% after the new funding round.

Key takeaways

Let us recap with some key takeaways around pro rata investment rights:

  • Pro rata rights can be  a good thing for investors. Negotiate them into your deal if you can.
  • Pro rata allows you to maintain your percentage ownership in a company through investing in future funding rounds to prevent your ownership stake from being diluted.
  • If the startup goes according to plan and progresses through subsequent funding rounds, pro rata rights give you the opportunity to double down on your investment and ride the wave to a potentially profitable exit.
  • Pro rata generally is not offered to small investors, but if you invest through an SPV as a group, for example, through Propel(x) syndicates, you may be able to get those rights included in your investment terms.
  • Existing pro rata rights may need to be sacrificed in later funding rounds to attract new investment.

Investors should keep in mind that these are high-risk investments and past performance is not a guarantee of future performance. These  investments are illiquid and there is no guarantee that an exit strategy will come to pass and investors can lose all of the money invested. 

 You can find more information here on how to start angel investing.

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