'Twas the night before Christmas and all through the country families had gathered around the hearth and reveled in the peace and quiet of the season. Children were on their best behavior having been reminded of the impending arrival of all-knowing Santa Claus. Angels and VCs had consumed large quantities of alcohol and food and were borderline comatose. Even the internet had slowed to a crawl. Not a creature was stirring….... wait, that is except for my friend @semil who catalyzed yet another epic tweet storm of opinion on Twitter- this time on the subject of pro-rata rights! The effect? Bile was spilled, ghosts were invoked for sure- but of course, it was a rollicking discussion. I too was roused from my reverie by @semil's unexpected X-mas rabble-rousing and he and I had the following exchange:
"Leave it to the one and only @semil to stir-up a pro-rata discussion on Xmas eve? :) " - dave lerner (@davelerner)
"LOL it was my master plan entirely! :)" - Semil (@semil)
"families of angels and VCs from NYC to SV are wondering where we all went :)" - dave lerner (@davelerner)
This wasn't the first time pro-rata rights had been discussed on the internet. Leading voices had weighed-in via their blogs. But I did note that plenty of folks on Twitter that night, (including plenty of would-be entrepreneurs), had little understanding of what pro-rata rights actually are nor how they effect real-life funding scenarios.
Also, as many have pointed out- with the advent of dozens of new seed funds, AngelList syndicates and the emergence of more and more super-angels, the "pro-rata" right at the very first round has become extremely relevant of late... 'tis the season for pro-rata rights indeed.
Let's do a quick definition so we're all on the same page and then I'll try to give my own perspective on the underlying dynamics via real-life scenarios.
Pro-rata rights allow an investor to maintain their equity percentage of a company, in which they have invested through multiple rounds of investment. As an example, if an investor has 0.5% of a company after she invests in the angel round, she "has the right" to maintain that 0.5% through subsequent funding rounds, by reaching back into her pocket and investing however much $$ it takes to maintain that 0.5% (so that dilution cannot be forced upon her).
DYNAMICS and SCENARIOS:
Scenario: Entrepreneur Raising an Angel Round
The entrepreneur is raising her angel round. Is it safe to assume that she would want her earliest investors, (who are backing her before she has had any success at the riskiest point of her startup's life), to at least have the right to maintain their equity percentage if she ends up doing well and raising more money. Right? Yes?..... Uh, well, sometimes, maybe not. What's going on here?
- Maybe she's a first-time entrepreneur and never even heard of pro-rata (this happens a lot!) Her lawyer may not include the term in the funding paperwork. One angel asks her about it and she speaks to her lawyer, who says something like "No, it's not necessary- when you raise future rounds- the VCs won't like it". Or maybe the lawyer says- "No- he's only putting in $25k, this is really for major investors- meaning people putting in $250k or more". Here, the entrepreneur doesn't know any better and might have an awkward conversation with her potential investor: "Sorry, counsel really has advised me against it".
- Now if that angel happened to be someone like Joanne Wilson (yes, she happens to be @fredwilson's better half), she might respond by saying: "If you don't give me pro-rata- I'm walking" and she might think to herself- (as she elaborates in this post): "That's bullshit". Joanne's general philosophy is:
"I will walk away from a bad document. I am also willing to walk away if I don't get my pro-rata rights. Many angels invest in the first round and sometimes they invest again in the second round, and then they are out when round three takes place. I don't want to be out. I feel like I took the biggest risk coming in at the very beginning and with that I want to continue keeping my percent of the company that I bought in the first round by continuing to participate (invest) in each round at my pro-rata share. I am in it for the upside. If the company is proving to be successful then I want to be rewarded in the upside for my risk."
- Others have weighed in here as well. Fred Wilson says, investing is like poker and you want to go all-in on your best hands . He says:
"Capturing pro-rata” is sooooo important in early stage venture."
- Or, as @Jason, (prominent angel investor), said in the epic Xmas-Eve Pro-Rata Stream:
"all angels should get prorata, period. if you don't get it you're a sucker." - jason (@jason) December 24, 2014
Of course you should give your earliest investors pro-rata, (if they want it). They are taking the most risk of anyone and should be able to participate in the upside (if there is one). To me this is just honest business. But this advice comes with a warning:
Only let value-add angel/seed investors into your round to begin with (especially in the cash-flush funding environment we are in now). You’ll be rewarded with a cap-table full of productive investors and a reputation as a stand-up entrepreneur.
Scenario: Entrepreneur is now Raising a Second Round (probably a Series Seed or Series A) An entrepreneur is raising his Series A. He had a great group of early-stage investors in the previous round, with fair documentation including, pro-rata rights. Because his company is doing extremely well he's being courted by multiple top-tier VCs. He ends up choosing a term sheet from Fund A that is syndicating with Fund B. The entrepreneur is looking for $3M total, and the two funds agree on a $9M pre-money valuation. Unfortunately for the previous investors, the VCs want the ENTIRE allocation. This means that they want to put in all $3M. They are not leaving room for anyone else. Gulp!
This is the "THEY SAY NO" scenario. You might remember it from this snippet from the opening scene in Gladiator. What now! Guess what- this happens all the time. The entrepreneur is a stand-up guy and wants to do right by his early investors and implores the VCs to allow for some room. So- what are the dynamics?
- The entrepreneur goes back to the angels and sheepishly tells them there is no room. Yes, they have pro-rata rights but the VCs don't care and having the entire $3M allocation is a condition of them investing. The entrepreneur asks the angels to understand that his hands are tied. Often what happens here is that the early investors are quite understanding but direct their ire at the VCs.
As @Jason mentioned in the Xmas Eve tweet storm:
"sharp elbow list" - jason (@Jason) December 24, 2014
- But what if one of the early investors is actually my fellow Brooklynite, @Jason, and he says:
"people are going to treat you as poorly as you let them; if you're right hold your ground. period." - jason (@Jason) December 24, 2014
- The entrepreneur might have to go back to the VCs again and say that some of the earlier investors won't budge. We now have one of these "ugly" scenarios involving what Mark Suster would call #RealPolitik. Here's his tweet from the Xmas Eve Stream:
Not really new normal. Always the case. Each party uses leverage #RealPolitik #Unpleasant - Mark Suster (@msuster) December 24, 2014
What are potential outcomes:
- The VCs might cave and open up a few hundred grand for some of the "prominent" early investors, (meaning the ones they want to piss off the least)
- There is a high likelihood that some of the early investors (smaller checks) will get cut-out
- The founder may actually decide to "sell" some of his shares to his early investors and "take some $$ off the table"
- No matter what some people will be angry and these folks have long memories
In these difficult scenarios, legal rights actually mean very little. It boils down to loyalties, relationships, leverage and reputations. Things can get ugly and feelings/egos will most likely be bruised. Even the most well-meaning founder can fail to navigate all these opposing interests and people will get angry and upset. There is no easy way through.
My practical advice is that if you are an early-stage investor you should have been absolutely doing everything you can to help the founder all this time. If you're a founder, fight like hell to honor your investors' pro-rata, especially for the ones that really helped you get you off the ground. These are the ones who have truly "earned their pro-rata".
Final Thoughts and Resources:
So you can see that I'm a big advocate of founders giving pro-rata to those investors who want it during the first round of funding. Of course this presumes that you have chosen your investors wisely and done your diligence on them.
In subsequent rounds founders should do everything they can to honor these rights- but when they are between a rock and a hard place- they need to go to bat for the early investors who added the most value along the way.
Some additional posts:
- Here's a humble post on the subject by @semil himself who describes his impressions as an investor relatively new to these dynamics.
- If you really want to understand more of the high-level dynamics and market forces at play with regard to pro-rata rights, simply read this tour-de-force by "Big Sus" himself. As usual, @msuster takes us through the many nuances.
- Aaron Harris from YCombinator has voiced his point of view here
- And Joanne has described one of her unpleasant experiences here