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Every day on AngelList, fund managers (known as general partners or "GPs") are making early-stage investments into startups. And as those startups mature and raise additional rounds of funding, some GPs want to invest in these subsequent rounds in order to maintain—or even increase—their ownership stake.
To do this, it can help to have pro rata rights.
Pro rata rights give GPs the option (but not the obligation) to invest in a company’s subsequent round(s) of financing. By participating in subsequent rounds, GPs can prevent their percentage ownership stake in a company from decreasing (often referred to as “dilution”). Dilution is not necessarily a bad thing, but GPs may want to avoid it if:
In this post, we’ll explain what pro rata rights are, how they work, and why investors care about them.
Pro rata rights represent an agreement between an investor and a company, whereby the company provides the investor the right—but not the obligation—to participate in one or more future rounds of financing.
Companies typically award these rights to select (not all) investors. Some investors may make the receipt of pro-rata rights a prerequisite to investing in the first place—others may not.
Early-stage companies may grant pro-rata rights to investors who are particularly helpful in an attempt to incentivize them. In later-stage companies, pro-rata rights are generally awarded to “major investors” (i.e. investors that have invested a major portion of the company’s overall financing).
Companies can raise capital from both investors who have pro rata rights, as well as from existing or new investors who do not have those rights. Pro rata rights are simply meant to guarantee an investor an allocation if they would like to invest it.
There are various flavors of pro rata rights and how much allocation an investor may receive is dependent on what exactly the pro rata rights agreement says.
Let’s walk through a common scenario.
The company Widgets, Inc. raises a seed round at a $3M pre-money valuation. Prior to the seed round, the company had issued 1.5M shares. So the price for each share of the company’s stock is $2. The company is now raising a total of $1M, issuing a total of 500k new shares.
The firm FastCapital VC invests $100k in the seed round. Since each share is $2, FastCapital receives 50k shares and thus owns 2.5% of the company (50k shares divided by 2M shares).
The founder of Widgets awards FastCapital pro rata rights to participate in the next financing round.
One year later, Widgets' founder decides to raise more capital as part of a Series A. The company has been doing well over the past year. The pre-money valuation of this Series A is $8M. So the price for each share that is being issued now is $4 ($8M / 2M shares). The company is raising a total of $2M, issuing a total of 500k new shares.
FastCapital has the option to invest in this Series A. The pro rata rights agreement stipulates that FastCapital can invest “up to an amount required to maintain its exact ownership % in the company.”
FastCapital’s ownership prior to the Series A was 2.5%. To maintain that same level of ownership, FastCapital will need to hold a total of 62.5k shares after the Series A (2.5% * 2.5M shares). That means FastCapital needs to buy 12.5k shares (62.5k - 50k). Since each share is $4, FastCapital’s pro rata allocation is $50k.
If FastCapital doesn’t exercise its option to invest, its ownership will decrease to 2% (50k / 2.5M).
Investors want to have pro rata rights so they can double down on companies that do well. Once a company is doing well, many other investors will want to invest and it becomes more difficult to get an allocation.
Take a look at Uber’s share price and its development over time. While early investors like First Round Capital realized the largest returns (5,000X return when Uber went public in 2019), even investors that invested in the Series A, B, or C generated large returns on their investments.
Aside from maximizing returns, a pro rata rights agreement offers several other benefits.
Since pro rata rights are options to invest in future rounds, GPs often use them when they pitch new investors (known as limited partners or "LPs") to invest in their fund. Said another way, pro rata rights allow LPs to predict which specific companies a GP may be able to invest in in the future.
There are several schools of thought around exercising pro rata rights. The first is that you should invest in subsequent “up rounds,” (i.e. rounds where the company raises at a higher valuation than in the previous round). This strategy is sometimes referred to as “doubling down on winners”.
The second is that you should invest in any follow-on round, regardless of valuation.
And the third is that you should not invest in any follow-on round, and instead use your capital to invest in new, early-stage companies.
There isn’t one “right” approach. A lot of it depends on your strategy, the valuation of the company, and how much capital you deploy.
Using AngelList data, we found that always following-on generates a higher expected (average or mean) return, whereas never investing in later rounds generates a higher typical (median) return. Selectively following on does not demonstrably outperform either extreme.
To evaluate the differences, let’s look at the total value paid-in (TVPI) of each approach. This measures the total gain of an investment expressed as a ratio.
The mean TVPI is higher for investors who always follow-on (gain of $0.90 for every $1 contributed), but the median TVPI is higher for investors who never follow-on (gain of $0.60 for every $1 contributed). Based on 100k simulations, we found that never following on outperforms always following on 54% of the time, while always following on outperforms never following on 46% of the time.
In other words, our data indicates that an investor is likely to have higher returns when broadly indexing. This is consistent with the power-law of early-stage venture investment returns, which suggests spreading your investments around to a variety of early-stage companies makes it more likely to hit on a winner than following on to just a few companies.
AngelList helps GPs in three main ways:
Through Rolling Funds, GPs can raise more capital from a diverse network of LPs on a continuous basis. This means GPs will have capital on-hand to invest when it comes time for a new round of funding. A traditional fund might already be fully deployed when an attractive follow-on opportunity arises.
And because Rolling Funds utilize SEC Rule 506(c) of Regulation D, GPs can market their breakout portfolio companies to attract new LPs. AngelList also makes it easy for Rolling Fund GPs to create special purpose vehicles (SPVs) to follow-on to their winners.
To learn more about investing on AngelList, visit our website.