If you’re new to investing in startups, it’s critical to understand how pro rata rights protect your investment. The term pro rata comes from the latin phrase for “in proportion.” Pro rata rights give investors the option to maintain their ownership proportion in a company through future rounds of fundraising.
Pro Rata Example
For example, suppose an angel investor puts $100,000 of seed money in a startup with a $1,00,000 cap. After the seed round the investor owns 10% of the company. If things proceeds well and the company offers another round at $2,000,000, the investor with pro rata rights has the option to invest $200,000 to maintain their 10% stake in the company. If the investor chooses not to invest in the next round, their stake in the company becomes diluted.
Dilution occurs when a company issues additional equity. In the previous example, suppose after the seed raise the company had a valuation of $1,000,000. As the startup gains traction, the valuation increases to $4,000,000 and the company plans to offer another fundraising round at $2,000,0000. The pre-money value of the company is $4,000,000. The post-money (after investment) value of the company is $6,000,000. If the investor does not participate in the second round, the investor’s ownership is diluted from 10% to 6.7%. because:
10% ownership at pre-money valuation of $4,000,000 = $400,000
$400,000 / $6,000,000 = 6.7%
However, if the investor exercises his right and invests an additional $200,000, the investor’s ownership remains at 10%.
Why Pro Rata Is Important
Startup investments are a high risk and high reward venture. When early investors see signs that a startup is going to succeed big, investors often wants to ensure they maximize their return through continued investment and maintaining ownership percentage. Without pro rata rights, early investors who take the most risk with startups can be left out of future opportunities. Remember, pro rata rights need to be clearly stated in any deal and the rights give investors the option, not the commitment, to maintain ownership percentages.