What is a pro-rata right?

Full Explanation

A pro-rata (or pro-rata participation) right entitles an investor to maintain their ownership percentage by participating in future funding rounds on the same terms as new investors.

Pro-rata rights protect investor ownership percentage against dilution from new rounds. If a Series A investor owns 10% and the company raises a Series B, the investor has the right to invest enough capital in Series B to remain at 10% ownership (all else equal). This is routine for institutional investors and is heavily negotiated. Series A investors typically demand pro-rata rights up to 1-3x their original investment amount. For founders, this is generally acceptable because it keeps existing investors aligned and prevents ownership from fragmenting across many shareholders. However, excessive pro-rata rights (e.g., unlimited participation) can lock out new investors or dilute the founder's ability to control allocation of future capital. Pro-rata rights are standard but the scope (how many rounds, how far down the ownership percentage) varies. Most VC term sheets include pro-rata rights for the lead investor and often for all Series A shareholders.

The interplay between different shareholder rights creates complex payout scenarios that founders should model before signing any term sheet. Pro-rata rights, tag-along and drag-along provisions, and conversion mechanics all interact in ways that can produce counterintuitive results. For example, a higher valuation round with participating preferred shares and a ratchet anti-dilution provision can leave founders worse off than a lower valuation with standard non-participating preferred terms. Modelling the payout waterfall across multiple exit scenarios is essential due diligence.

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