Pro-rata rights protect startup investors from having their ownership stake get diluted during subsequent rounds of funding.
For example, let’s say you own 10% of a startup thanks to investing in it when the company launched. When that startup kicks off a new round of funding, you’re entitled to 10% of the new shares issued. This way, your initial investment can stay in proportion with the issuance of new equity.
What are the drawbacks of investing pro rata rights?
For investors, there are no real drawbacks to pro-rata rights, especially considering they can waive them if they don’t want to use them. However, there is some potential downside for startup founders. Namely, if a startup is successful and grows, finding new investors is easy and may be preferable to taking more capital from existing investors since new investors can bring in new perspectives and expand the company’s network.
How pro rata works in venture capital deals
It’s important to note that startups don’t have to grant pro-rata rights to anyone. However, it is an effective way to convince early investors to take a chance on your company. And because pro-rata rights benefit the investor more than the startup, founders, for the most part, only give pro-rata rights to major investors. It’s often a matter of who has the most leverage. Another couple of key pieces: While an investor is entitled to new shares thanks to their pro-rate rights, that doesn’t mean they get them for free. They have to raise the money to acquire the new shares. And to protect startups, pro-rata rights typically only apply to the subsequent round of funding after the rights were granted.
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