by akharris on 10/11/21, 2:47 PM with 42 comments
by jamiequint on 10/11/21, 11:33 PM
It's also incorrect to frame the option as "free", you're only observing market behavior in a world in which the option exists, not one in which it doesn't exist. You can't say that investors would have the exact same behavior (in terms of prices, terms, etc) in a world in which they rarely or never got pro-rata. Maybe, but probably not.
by nikhizzle on 10/11/21, 11:19 PM
If the company is scaling quickly, and looks like it could have a good return, a later stage investor could come in and cause massive dilution in the cap table by issuing many shares and granting some amount to the employees and founders. If I had pro rata, I could have a proportional share of the funding, and even if in the likely case I didn’t have the capital I could likely raise it, and at least get some share of the upside.
by eftychis on 10/11/21, 10:15 PM
But yeah you should pick an investor according to what you want-- help and advice as part of the package is valuable and good investors and advisors give it openly.
Curious of course on feedback on this -- do other people get different numbers? P.S. Maybe that is the idea for this post from someone from YC? Push away other future investors? :D
by drinkzima on 10/11/21, 10:01 PM
by robotresearcher on 10/12/21, 12:15 AM
by mchusma on 10/12/21, 1:28 AM
So pro rata is just one in a basket of investor friendly terms.
by aeternum on 10/11/21, 11:59 PM
Terms can often be ambiguous so this helps ground the article and ensure everyone is talking about the same thing. There are also plenty of HN readers who have no idea what it refers to that would also benefit greatly.
by JumpCrisscross on 10/11/21, 10:42 PM
On the flip side, I'd love for a founder to give me a discount for agreeing to take out these boilerplate terms I have--as an angel investor--zero interest in adversarially leveraging.
by jacquesm on 10/11/21, 11:59 PM
by bsder on 10/11/21, 11:48 PM
Power and goodwill are what count.
However, contracts matter once outsiders start getting involved. The contract (hopefully) isn't there to bind the original parties much, but it matters a LOT once someone much more adversarial enters the picture.
by joshu on 10/12/21, 4:10 AM
yes, pro-rata is a bit of a pain on up rounds, especially in terms of letting later investors get the ownership they want. but on a down round, previous investors get wiped out very aggressively; they need the protection to be able to at least maintain their stake.
(personally, i will typically go with whatever the founder wants. "it looks bad if you don't take your prorata" or "i can't get enough room for the new investor" and so on. if a new investors adds terms to strip previous investors of their rights, i will insist on it, though.)
by irjustin on 10/12/21, 2:18 AM
> I insisted on getting pro rata in tight rounds where the founder wanted to bring in new investors or limit dilution.
> I learned this through rough conversations with founders who expected a pro rata investment during a difficult fundraise and didn’t get it.
The 2nd situation isn't really something to protect against. To expect pro rata during a difficult fundraise is weird because the expectation is to be able to force someone to invest in your dying company? A non-situation to me.
The 1st one is the most realistic and understandable. Hot rounds really become a fight of letting the right people in at the right price. Without pro-rata small guys would disproportionately not be able to continue their investment.
So then it becomes negotiating with the incoming round's lead to lower post-money to avoid overall dilution.
Which, is always a welcomed problem.
by sytse on 10/11/21, 10:28 PM
by thruflo22 on 10/12/21, 8:21 AM
So similar to vesting for rights — a founder / employee needs to continue to be active to continue to vest. Ideally an investor could continue to be active to continue to exercise pro-rata.
It’s pretty hard to enforce / codify “active” for an investor though and could just result in time wasting by pretending to be involved helpful when just coasting. Was that intro genuine or just designed to protect the pro-rata?
by duchenne on 10/12/21, 8:41 AM
Am I missing something?
by jollybean on 10/12/21, 2:19 AM
But the author doesn't indicate how that can be problematic.
How do existing requirement to allow previous investors in the round, contribute to a 'warping' or 'problems'?
I mean, if pro-rata is only designed to prevent dilution - well that should not be so bad. That means in any given new round, there should be enough room for new investors, no?
It also should be less painful in early rounds when investors own a smaller amount.
Would it possible to do 'partial pro-rata'?
by hstern on 10/11/21, 4:38 PM
by rexreed on 10/12/21, 11:36 AM
This site [0] does the best job explaining what Pro Rata rights are and why are they are important to both investors and their potential issues:
"Pro-rata right is a legal term that describes the right, but not the obligation, that can be given to an investor to maintain their initial level of percentage ownership in a company during subsequent rounds of financing.
In other words, if an investor with a pro-rata right initially acquired a 10% equity stake in a company, then he or she is given the option to invest more in the next rounds of the company’s financing to maintain a 10% stake.
...
The idea of a pro-rata right is essentially related to the concept of dilution. Each new round of equity financing implies the issuance of new shares. When new shares are issued, the percentage of the equity stake of current shareholders (founders, investors) is diluted. In other words, the current shareholders lose part of their voting power as calculated on a percentage basis.
In order to prevent such a scenario, the investors can ask a company to include a provision that grants them pro-rata rights. The investor with the pro-rata right is then able to maintain the percentage of their equity stake and voting power even with the issuance of new shares.
Note that the pro-rata right is not an obligation, and it can be exercised at the discretion of its holder. Some investors with pro-rata rights may opt not to exercise their option to invest in the next rounds of financing. The reasons for abandoning the rights include poor performance or development of a company, as well as extremely large additional investments required to maintain the initial ownership percentage.
In addition, in some cases, investors do not receive pro-rata rights. Some companies opt to grant such rights to valuable investors who have made a significant impact on the business.
Pro-rata rights are generally granted to, or asked for by, investors who invest in early rounds of financing. The investors are often not willing to exercise their rights in the later financing stages due to the high investment amount required."
As per above, the option to maintain the investor's initial equity is entirely up to the investor in subsequent rounds. However, this option is not afforded the founder. The founder is not able to maintain their ownership across rounds, because, for evident reasons, the equity that is granted to the investors necessarily comes out of the founders' shares. It has to add up to 100% (this can't be the startup version of The Directors).
One way I like to visualize this is like a growing pie. Like an actual pie, perhaps apple or blueberry, or pumpkin or chocolate silk.
In the beginning the pie is really small and can fit in the palm of your hand. It's all your pie that you and your founders can share. It's so small you can probably each eat it in one or two bites.
Now someone else is interested in your pie and contributes money (ingredients) to increase the size of your pie. They increase the size of your pie in exchange for 1/3 ownership. Now 1/3 of the pie is the investors to eat, and the other 2/3 is yours. You don't own all the pie anymore, but you and your founders can eat your portion of the pie now in two bites each. Hey the pie has grown for everyone, even if you share is smaller, your portion is more bites than it was before.
Now your pie is looking pretty darn attractive and someone else wants in. So a new investor puts in even more ingredients and really increase the size of the pie. In exchange, they take 1/3 of the pie. That shrinks your portion of the pie even further, and even that of the previous investor. The previous investor really likes your pie and they're not content with the number of bites they had before since the pie is so much bigger. They want more bites. So they chip in along with the new investors to keep their stake at 1/3 of the pie.
At this point, the founders have 1/3 of the pie, the first investors have 1/3, and the new investors have 1/3. The pie is much bigger, and everyone has many bites. In the beginning the founders had the whole tiny pie to themselves, and now they have 1/3 of a much bigger pie. They also have more people invested in the pie. It's not entirely your decision on what happens to the pie. Just hope it keeps growing so that when you sell your pie (assuming you haven't eaten it), it will go to someone who will buy that pie for more than the cost of the ingredients and all the time you spent on it.
[0] https://corporatefinanceinstitute.com/resources/knowledge/fi...
by parkerjamie1993 on 10/12/21, 8:42 AM