What are Pro-Rata Rights?

In financial terms, pro-rata rights allow an investor to maintain their portion of ownership in a company when the company takes on new investors.  

Company Valuation and Pro-Rata Rights

It is important to understand the role that the valuation of your business has on pro-rata rights for other investors. This is important because the angel or venture capital investor dilutes the shares of other owners. Other owners in early stage businesses are typically the owner (or owners) and friends and family members. Initially your company may look like this:

  • Owners/Founders - 50 percent equity each; or

  • Friend and family investors – each owner/founder surrenders 5 percent and 10 percent is given to friends and family (founders/co owners now have 45 percent each)

At this point, you will typically have registered your company with stock to ensure you can actually issue stock to family or friends who invest in the company. As part of your overall structure your equity positions now look like this:

  • Owners/Founders - 37.5 percent each (X2 = 75 percent)

  • Friends/Family - 5 percent

  • Reserved for future investors or employees – 20 percent

If you now need a sizable investment to keep your business going, you will seek out financing from an angel investor. Now company valuation comes into play. Let's assume for a moment that an angel investor believes your company is  worth $1,000,000. Then they decide they are willing to invest $200,000 into your company.  

To determine the investor’s percentage of ownership you must take the valuation into consideration:

  • Value established by investor = $1,000,000

  • Investment by investor + $200,000

  • New Company Value: $1,200,000

To determine the investor's "share" of equity, you divide what they invested into the new company value: +200,000/1,200,000 = 0.016667 or 16.7 percent

Going forward, the investor’s share is based on their "pro-rated" investment of 16.7 percent (not the original 20 percent you had set aside).

Each time a new investor invests, they increase the valuation, thereby diluting the original investor’s percentage. For example, let's say another investor adds $200,000 in capital to your company at the $1,200,000 valuation. The new company valuation would be $1,400,000 and their investment would net them 14.3 percent of the company (0.142857).

At this point the original investor’s pro-rata rights would kick in. They would have the option to buy enough shares from the Company to bring their percentage back up to 16.7 percent of the company. Though the company will receive extra cash, this will inevitably dilute the founders’ percentage ownership.

Why Pro-Rata Rights Are Important to Investors

Investors are interested in pro-rata rights because as your company grows, they do not want their equity diluted. Simply put, the more successful you are, the more involved investors wish to be in the company. Keep in mind, as you take on additional investors, your business value grows. The more investors involved, the lower the percentage the initial investors own, unless they exercise their pro-rata rights.

Why Pro-Rata Rights Are Important to Entrepreneurs

One of the good things about pro-rata rights is you may be holding early investors long-term. While not every investor will exercise those rights, you may be able to use the fact you have investors who have these rights as a negotiating tool for future financing (see the markup game). As a founder, you may also be able to sell portions of your equity to an investor who wishes to exercise their rights. You will be diluting your ownership portion, but you have an increase in personal wealth nearly immediately.

Angel Investors and Pro Rata Rights

If you are seeking out angel investors, chances are they are investing in only a few companies they think are going to prosper. In most cases, they will want to have a pro-rata agreement. This is because they do not want to miss out on future rounds of financing.

What to Be Aware of with Pro-Rata Rights

When negotiating with an investor about pro-rata rights make sure you are not boxing yourself into a corner. If you go through multiple stages of financing and give pro-rata rights at each stage, you could find yourself with a host of problems. Larger investors often want a bigger piece of equity; if you have promised to keep early investors involved in funding, you could face challenges with new financing.

Pro-Rata Rights and Management Decisions

Angel investors and venture capital companies often wish to have a say in your company's management. This often involves putting a qualified person on your board of directors. As you give up equity in the company, you could have minority investors who hold board positions.  

Pro-Rata Rights and Future Financing

Keep in mind pro-rata rights may also hamper your ability when it comes to securing future financing.  Those who hold those rights have the option (but not the requirement) to invest more money. Should they decide to exercise their rights, your freedom of action in securing new financing could be limited.

There are three stages of second-round financing that could impact pro-rata rights:

  • New investors want to get involved with a successful company

  • New investors want to dictate how much equity is available for existing investors

  • An agreement of allocation is worked out between the founder, and the new and past investors.

In financial terms, pro-rata rights allow an investor to maintain their portion of ownership in a company when the company takes on new investors.