What are pro rata rights?
Pro rata rights give the investor the right (but not the obligation) to invest more money in one or more future fundraising rounds to preserve their ownership percentage in the company.
Why do investors want pro rata rights?
Pro rata rights allow investors to maintain their level of ownership in their most successful portfolio companies as these companies grow, especially if fundraising rounds become oversubscribed. For early-stage investors, pro rata rights guarantee a seat at the table during a Series A round. For later-stage deals, some rights (like having a board seat) require a minimum ownership stake, so pro rata rights allow investors to maintain their stake, and thus maintain these rights.
What do pro rata rights mean for the entrepreneur?
If the subsequent funding round is oversubscribed, then the pro rata right limits your flexibility in allocating the round. For example, suppose you are a health tech startup raising a $3 million Series A round. Tier 1 Capital, a prestigious VC firm known for its operating expertise, wants to lead with a $2 million term sheet, and Anatomy Capital, a founder-focused health tech fund, wants to invest $1 million. Your early investors (who haven't been very helpful beyond writing the first check) decide to exercise their pro-rata rights, allowing them to invest $1 million. This leaves you with only $2 million left in the round, and you are unable to accept Anatomy Capital's term sheet.
How do pro rata rights impact my cap table?
Pulley's modeling feature allows you to model the impact of pro rata rights on your cap table. View this 2-minute video to learn how to use the modeling feature.
Let's go through an example. Sam and Mandy, cofounders of Galactica Inc., are raising a Seed round and have a term sheet from Z Combinator for a SAFE investment. They want to understand how accepting the Pro Rata right would impact their cap table if they raised a hypothetical $3 million Series A round.
They model out two Z Combinator SAFEs – one with Pro Rata, and one without Pro Rata.
To see the impact of Pro Rata on the cap table, they check the box next to the "Pro Rata" SAFE and uncheck the "No Pro Rata" SAFE. This scenario shows that Z Combinator exercised their Pro Rata right and invested an additional ~$135,000 in the Series A round to maintain their ownership percentage at 4.55%. The remaining allocation in the $3 million Series A round left for the new Series A investor was ~$2,865,000. The Series A investor's ownership is 20.45%.
To see the impact of no Pro Rata on the cap table, they check the "No Pro Rata" SAFE. This scenario shows that Z Combinator's shareholding decreased to 3.57%. The new Series A investor can claim the entire $3 million round and therefore have a higher shareholding of 21.43%.
How do I know if my SAFE or term sheet includes pro rata rights?
For Post-Money Y Combinator SAFEs, pro rata rights are typically included in a Pro Rata Side Letter. For Pre-Money SAFEs, this term is a default component of the document. For equity rounds, the pro rata right can be found in the term sheet, typically under the heading "Right to Participate Pro Rata in Future Rounds."