Yesterday I saw a Tweet from Chris Sacca fly by that prompted me to want to write a blog post helping entrepreneurs understand why they should push back against VCs asking for “super pro-rata” rights. I’ll explain what they are and why you should avoid them if you can.
A primer on “pro-rata” rights
Institutional investors will always insist on pro-rata rights. This is not something to be concerned about. All it says is that the VC has the right (but not obligation) to invest his/her proportional ownership in the next round of financing. Typically this means, for example, if the investor owns 20% of your company from the A round they have the right to take 20% of the next financing (and continue provided that this right survives the next financing).
There is a lot of confusion about how pro-rata rights are implemented as evidenced by this post by Seth Levine of Foundry Group.
Pro-rata rights are designed to protect investors from being diluted in future rounds of financing, which is an important way for VCs to protect the investments they make early that turn out to be super successful.
You can image if you were the A round investor in Zynga and saw it scaling quickly that you’d far rather put $5 million more into something that will obviously be a success than you would want to put that $5 million into a new, totally unproven deal.
So at the time that the initial VC funds you they’ll be thinking about protecting this right as depicted in the graphic below.
Obviously the situation is very different in companies where the company isn’t “killing it.” Pro-rata rights in these cases are normally exercised as a confidence building measure to ensure incoming investors that you still believe the company has upside. If you’re the A round investor you’ll often put in your pro-rata amount if required even though you might prefer not to.
If you’re invested $5 million to date and a new investor will put in another $5 million then in a sense that follow-on investor is protecting your initial investment by extending the runway of the company. Without them the initial investor has a choice of continuing to fund the company himself, letting it go bankrupt or trying to sell the assets and recover as much of his original investment as possible.
Putting $1 million into a new round to protect $5 million if new investors are willing to pick up the balance of the funding is often considered a smart bet.
In deals that aren’t hotly pursued new investors are looking for this support as depicted below.
Before explaining “super” pro-rata rights it’s important to understand the tension that often exists when you have a company performing very well and raising money from a large, brand name Silicon Valley investor. These investors often have internal policies that dictate that they own a minimum percentage of a company in which they invest. Of course every firm breaks its rules to get into a deal, but they put pressure on you by saying that they can’t.
“It’s 20% or nothing. That’s our firm’s policy”
I find that kind of black-and-white rule silly, but trust me people say it all the time. As though 18% of a big company is a terribly embarrassing outcome. Mostly I think the “minimum or we’re out” is just a strong-arm negotiating tactic.
So if you’re raising $10 million and only want to face 20% dilution and that’s the threshold for a new investor, you’re going to see tension. Why? Because existing investors will want to put their pro-rata money to work.
What are “super” pro-rata rights
So with this set up, what are “super” pro-rata rights? In the case of a super pro-rata right the investor (let’s say in your A round) will ask for MORE than their pro-rata right. They might own 8% of your company after the first funding but demand up to 33-50% of your next round of financing.
Why would this happen? Often it’s when a larger fund (e.g. non seed / micro VC fund) wants to put in $500k (less than their typical investment) but wants to have a marker on your company if you end up being super hot. In my mind, it’s almost like a dog pissing on its territory. Read: it’s an option for that investor and a super expensive one to you, the entrepreneur.
Why you should avoid super pro-rata rights
Why should you care? If they’re willing to put more than their percentage ownership why would I want to stop them?
Easy. You might make it difficult for you to get your company funded in the next round.
1. If you’re uber successful funding is never an issue. But if you’re reasonably successful such that the VC with super pro-rata rights wants to take his 50% of your new round and your other existing investors want to take their pro-rata rights, too, then there might not be enough for a new outside investor to feel motivated to write you a check. While I think steadfastly saying “20% or nothing” is silly, I do believe that new investors should own enough your your company to take the investment seriously.
So you’re stuck with an internal financing and no leverage to drive a fair price for yourself.
Note that the VC who had this super pro-rata “option” might have delivered tremendous value to your company and you might be OK with their taking a larger stake. They might have also done absolutely nothing and you’re now stuck with them owning more. They had a free option. You allowed it.
2. Consider the other scenario – where your company is doing OK but not amazing (e.g. the overwhelming majority of the time in early stage startups) and let’s say that the super pro-rata VC doesn’t exercise his right (remember, it’s a right, not an obligation to take more than his share). Now you’re forked. Remember the discussion above where the new investor is looking for the existing investor to take his pro-rata rights in order to prove that he’s confident in the business because existing investors have inside information.
Well, it’s far less likely that a VC marking his territory with a super pro-rata is likely to exercise that right if you’re not performing incredibly well. This same VC would almost certainly have taken his simple pro-rata investment. But the fact that he isn’t stepping up for more than his existing ownership despite having the right to do so is one big red flag for new investors.
How entrepreneur should talk to VCs about increasing ownership percentages over time
First, you need to be clear that any larger fund writing a small check IS ONLY doing it so that they have the opportunity to invest at a later stage if you’re doing well. That’s why you don’t want a bunch of non-seed VCs taking small investments in you. It’s fine to have one. Often it’s a good idea. Two at a push. But if you’re “collecting logos” (as I warned about in this post) then I don’t feel sorry for you if you have tension at future financing rounds.
So here’s what I now say to every young company for which I write a sub-$500k small check to as part of a larger round,
“I want to be clear. I’m writing this check because I hope that I can lead your next round if you’re doing well.
I’m not asking for a commitment from you. If I prove that I’m a valued investor from now until your next financing I’m hoping you’ll give me extra consideration. But you’re not required to. I have to earn the right.
Equally, if you’re not performing well, I’m not committing now to lead your next round.
So each of us can be held accountable for our performance from here.”
If I were you I’d use this same line in reverse. Tell the VC that if they perform well and help you they’ll have a leg up on any outside investor but you obviously can’t guarantee anything. Equally tell them that you know that if you didn’t perform they obviously wouldn’t continue to invest. So you don’t feel comfortable with a free option now. Feel free to send them this post. The may not be happy with it, but it’s pretty hard for them to dispute this logic.
One warning I always like to make clear: when you have choices in life you can feel the luxury to follow my advice in this post. If you truly need the money and don’t have other choices, take the money. It’s not a terrible term. It beats a swift kick in the arse.
Final Note: I know one team (and investor) that will be grimacing reading this post. Disclosure: I once had super pro-rata rights on a deal. It was extenuating circumstances, I personally wasn’t pushing for them, it left a bad taste in my mouth and I swore I’d never ask for them again. I think the CEO of that company would say that I did the honorable thing in the end on that deal. But I didn’t want to write this article without this small disclosure. Even VCs need to learn through mistakes.
(Cross-posted @ Both Sides of the Table)