Among the most important rights that investors have is pro-rata participation. This is especially true for investors in tech companies since they give the investor the right to participate in future financing rounds and to maintain their ownership percentage.
The Changing Pro-Rata Landscape
Up until several years ago, pro-rata rights were given to larger investors in later rounds, less so to angel investors. However, it’s now becoming increasingly common to find angel investors demanding pro-rata participation.
The reason is a purely economic one: there’s simply a whole lot more angel investors with a whole lot more cash. The result is that tech startups have access to far more capital than ever before. What you’re seeing now is the mushrooming of larger tech startups with pretty beefy capitalization . Combine that with unprecedented speed in their growth and that means more companies that are giants by the time of an IPO.
This simple graph from J’son & Partners will immediately show you the expanding wingspread of angel influence, and why there’s more competition with VCs in later rounds:
Here’s a simple example to show you how it works for smaller angels:
Angel puts $500k into your company for a 10% ownership interest. If the company raises $20 million on the next round, angel might not be able to inject the $2 million that would be required to preserve their 10% ownership stake.
As you can see, even if this angel were given pro-rata rights, it doesn’t mean they would be able to execute them, since in this example we’re assuming that the investor doesn’t have the cash to keep their 10% stake.
You can see how easy it is for an angel to feel like they’re being pushed out by the more weighty investors in the room.
What’s happening now, however, is that there’s a fairly abundant number of extremely high net worth angels who are ready, willing and able to put significantly higher sums into later financing rounds. Since they have the means to participate in those later rounds, they want to maintain their percentage of ownership, and pro-rata rights allow them to do this.
Cutting the Seedlings
Investors are wealthier and more sophisticated than ever before. They rely on their due diligence when making the decision to invest, so signaling doesn’t necessarily carry the weight it once did.
Consequently, the heat is being turned up in these later funding rounds as seed investors are fighting more for their pro rata rights, while later investors want to maximize their gains.
In order to visualize the rapid rise in seed round funding, take a look at this chart from CB Insights:
Some later stage investors take an all-or-nothing approach by threatening to pull out of the deal if seed investors don’t surrender their pro-rata rights.
But this is not true for all later investors. I’d suggest that later stage investors who are opting to find a more balanced way forward tend to promote not just better deals, but also a stronger organization.
Ultimately, the later stage investor’s decision is philosophically-based. The primary take-away here is that later stage investors don’t come in just one color: there are many shades along a broad spectrum of advanced investors.
My advice would be to do some due diligence as early as possible – and certainly before a Letter of Intent and Term Sheet – to make sure this is an investor you’ll be comfortable with.
Entrepreneurial Advantage: It’s a ‘Seller’s’ Market
Entrepreneurs have the opportunity to leverage the growing competition between seed and later stage investors. Since VCs have growing appetites to own as much stock as possible in a promising tech startup, they’re more willing to allow founders to take money off the table pre-launch.
Take a look at this chart from Business Insider (Aug. 29, 2015):
While many founders usually hold their shares until IPO or sale, some are opting instead to cash out early. The reason gets back to the changing landscape: more investors – seed and VCs – with extraordinary cash reserves.
If I’m a VC who wants to have at least a 20% stake in your hot tech startup, I’m going to be willing to secure my position by paying founders to take an early exit in exchange for a larger portion of the pie – and potentially far greater gains down the road.
Some founders are incentivized by these lucrative early exit offers. Take for instance two 30-something year old founders of Secret, a messaging app, whofrom selling some of their shares in an early round of financing.
Like with most things, there are tradeoffs and moderation is the operative word. Ideally, the interests of founders and investors should be aligned. If a founder’s early liquidity feeds off the intensity of investor competition and their exit payoff is too high, it could be damaging to both parties’ interests: Founders’ creativity and drive could become flat and VCs won’t get the value of founder expertise to create a winning product.
Look for Win-Win Strategies
As a founder, one of the best things you can do is to understand who your investors are and what drives them. While it’s common to find VCs who disfavor an angel’s pro-rata rights, there are others who are finding innovative ways to accommodate everyone’s interests.
For instance,uses an approach that’s inclusive of angel and micro-VCs. His strategy is to guarantee angels their pro-rata rights, subject to a clause that gives the majority of their class of preferred shares the right to waive pro-rata participation in whole or in part. If the majority votes to waive their rights, then everyone in the round is required to waive their rights.
An additional clause provides that if the majority does exercise its pro-rata rights, then they’re required to offer the same deal to early investors proportionate to the majority. For example, if he’s 80% of a round, but decides that it’s more sensible to take only 40%, then all investors in the round must adjust their percentages proportionately. This approach assures a more equitable accommodation of the rights of angels and later stage investors.
Final Thoughts for Frothy Times
Anything can change on a dime, so founders – especially of tech startups – are well-advised to consider how the competition between angels and later investors over pro-rata rights can best work to their advantage.
Each company has its own unique set of circumstances. Your angels might have pro-rata rights, but this doesn’t mean they can enforce them. For example, if their investment is a relatively small one, even with pro-rata rights, they might not be able to participate because they don’t have the means. If they do have the means, VCs might insist those rights be surrendered or they (the VC) will walk. Or, the VC might find a way to appease everybody’s interests.
This isn’t a substitute for legal advice, so you really need to engage an experienced attorney to help guide you through this process. Feel free to check outfor to connect with an experienced startup attorney about structuring your deal. You can also message me directly with any other questions.