Lee Edwards, a partner at Root VC, emphasizes that “pro rata rights are earned, not given.” Pro rata rights in VC term sheets allow investors to maintain their ownership percentage in a portfolio company by buying more shares during subsequent funding rounds, avoiding dilution.
Though not technically earned, exercising pro rata rights can be costly. A growing trend in VC investments is the emergence of funds dedicated to assisting seed VCs in exercising their pro rata rights.
The challenge arises in later funding rounds, where new lead investors often secure preferred allocations, leaving existing investors to pay the same price per share if they wish to exercise their pro rata rights. This dynamic sometimes pits new investors against earlier ones and adds complexity to founders’ decisions on capping the amount of their company they sell in a round.
The negotiation process can be intense, with downstream investors pressuring founders to allocate larger portions, potentially squeezing out pro rata investors. In these situations, earlier investors rely on founders advocating on their behalf.
Securing capital to stay in the game
In the VC landscape, some investors choose not to exercise their pro rata rights due to financial constraints or high valuations. This dilemma became more prevalent during the recent VC investment surge from 2020 to 2022.
To address these challenges, investment firms like Alpha Partners, SignalRank, and SaaS Ventures have emerged, providing capital support for seed-stage and Series A VCs looking to exercise their pro rata rights in later rounds.
SaaS Ventures partner Jesse Bloom highlights the importance of quick decisions and access to top-tier VC funds to participate in later-stage deals. This strategy can provide leverage in negotiations and ensure continued participation for early-stage investors.
Bloom’s success in securing capital for pro rata opportunities highlights the growing trend of targeted funds for pro rata investments. Other firms like SignalRank and Alpha Partners are also raising funds to focus on pro rata deals, reflecting the heightened competition in the VC market.
Pro rata boom
The increase in pro rata deals signifies a shift in investor behavior, with more funds being raised to capitalize on pro rata opportunities. The demand for such investments stems from fewer deals being done at later stages, creating challenges in securing access to lucrative deals.
Notably, the trend of pro rata investment has gained momentum in recent years, driven by the need for investors to double down on their winners and secure their positions on company boards.
Educating VCs on the importance of exercising pro rata rights and building strong relationships with founders can enhance their long-term investment strategies and maximize returns.
