Nutshell: Taking seed investment from institutional investors is supposed to be akin to getting engaged; they’ve made a credible commitment to you, but your options are still open to walk if a better Series A partner shows up. However, if you don’t read an investor’s “pro rata” terms carefully, you’ll find that you’re no longer the bachelor (or bacholerette) you thought you were.
- Large seed round investors have an incentive to gain as much control over the composition of your Series A round as they can get – to maintain (or increase) their ownership % of the cap table, and to reduce competition from new outside investors, who might be better for your company.
- Founders’ interests, however, are completely the opposite – get large, influential seed investors on the cap table, but minimize their ability to control who leads the Series A. The greater the flexibility in taking Series A term sheets, the more competition, the higher the valuation for the company.
The Main Issue
No one covers the entire issue of why prorata rights are important to seed investors better than Mark Suster: What all Entrepreneurs Need to Know About Prorata Rights. Because of the economics of seed investing, the ability of seed investors to secure follow-on positions in their “winners” is critical to their portfolio returns. Also, institutional VCs will typically only write seed checks if they have a reasonable shot at securing a substantial position (15-20%+) in a Series A round. For these reasons, seed investors will often require, as a condition to their investment, the right to make follow-on investments in future rounds. These are usually called “pro rata” rights because, on a basic level, the investor gets the right to purchase her “pro rata percentage” of future rounds. But the point of this post is that how “pro rata” is defined can have substantial consequences in future financings.
While seed investors’ requiring some form of pro-rata is understandable (I’ve found California seed investors demand it much more often than Texas investors), Founders need to be aware that the more follow-on investment rights they grant in their seed, the less flexibility they have in bringing in large, potentially better VCs in the Series A round. That “bigger fish” that wasn’t around for your seed round will expect at least 15-20% of the Company in the A round, or it won’t “move their needle.” Getting that VC to this threshold becomes very hard if you’ve already promised your existing investors a huge portion of the A-round.
Being too relaxed about your seed investors’ follow-on investment rights will either (i) force you to give away a very large percentage of your company in the Series A (to “feed” everyone), and/or (ii) give your existing investors the ability to block a term sheet from that outside investor you really want.
Pro Rata of Fully Diluted – The Classic Engagement.
By far the most common (and company favorable) definition of “pro rata” in seed rounds is pro rata of the Company’s fully diluted capitalization. This means that the denominator by which the particular investor’s ownership is divided (to determine their pro rata %) is the entire capitalization of the Company, including outstanding shares, options, warrants, and shares reserved but unissued under the Company’s equity plan. So, for example, if Investor X paid $50K for 100,000 shares, and the total fully diluted capitalization is 5,750,000 shares, then his pro rata percentage is about 1.74% (100K/5.75MM). If you do a new $1 million round, Investor X has the right to purchase 1.74% of that round.
But a very important wrinkle is that, if the seed round in which the rights were granted is a convertible note round (it almost always is), the investor’s ownership percentage isn’t set yet; so there’s no easy way to calculate the formula. The note needs to be converted (or at least assumed converted) to arrive at a %. Without getting too much in the weeds, there are a lot of variables here that can influence what % the investor eventually gets:
- Does the pro rata right only kick in once the note is converted? If so, then the Company can raise more note rounds (without having to offer pro-rata to existing investors), and those notes will convert alongside Investor X’s note, shrinking his pro-rata %.
- Do we assume conversion before it actually happens? If so, do we assume it as of the date of issuance (fixed pro-rata), or the date in which the pro-rata right is being calculated (variable, potentially diluted by new rounds)?
The devil is in the details, and the details heavily influence what % an investor is ultimately entitled to.
Pro Rata of the Existing Round – The “You’re Really Married” Version.
On the other end of the spectrum is a significantly less common definition of “pro rata” that nevertheless pops up on occasion in seed rounds: pro rata based on the existing round. Here, the denominator for the formula is not the fully diluted capitalization, but the round in which Investor X invested – a substantially smaller denominator, and hence a much larger percentage. Example: if Investor X made a $50K investment in a $500K seed round, her “pro rata” under this formula is 10% ($50K/$500K).
Did you see what happened? A tiny variation in the pro-rata language increased Investor X’s pro rata % nearly 6-fold. And if you’re really paying attention, you’ll realize that, if everyone in your $500K seed round got these pro-rata rights, you’ve just given your seed investors first dibs on your entire Series A. While it’s not as crazy to give your Series B investors first dibs on your entire Series C, since they’re likely deep-pocketed VCs whom you already have a long-term commitment to, giving your seed investors that kind of control of your Series A is dangerous. It’s the startup equivalent of getting married when you’re 16, before you’ve had a chance to mature and find “the one.” Be careful.
Other Follow-on Rights
We sometimes encounter other variations of follow-on investment rights that aren’t quite pro-rata rights, but they’re worth mentioning because investors are requesting them for the same reasons. Warrants granting the right to purchase a fixed $ amount in the Series A are sometimes requested. I’ve also seen side letters stating flat out that Investor X gets first dibs on Y% of the Series A. Obviously, like any provision, it ends up being about leverage and the type of investor you’re negotiating with.
The guiding principle for founders should always be to put a limit on their seed investors’ follow-on investment rights. I personally believe that straight pro-rata of fully diluted is fair and reasonable, but anything above that is overreaching by seed investors trying to control the A round. By all means keep your seed investors interested and informed, and ensure they are offered the opportunity to lead your Series A. That’s why they bet on you in the first place. But the opportunity to lead the Series A is very different from the right to lead the A. If someone demands the latter, it’s time to get serious, because you just got a marriage proposal.