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Pro rata is an option for investors to invest in future rounds. it comes at the cost of additional dilution for founders. Over several rounds it can be quite damaging to founders’ ownership. Pro rata also has severe negative signal issues in future rounds if existing investors don’t participate. These existing investors won’t promise that they’ll do the whole deal, only that they’ll pile in once you have one. There is literally no upside to founders in giving out pro rata rights. It is simply a costly pro-investor feature that has been worked into and accepted as part of a standard silicon valley termsheet.
Over our 4 rounds, Uber investors barely utilized their pro rata rights, but fought tooth and nail to keep them. I once had an investor so jacked up on pro rata that they traded away a board seat to keep their pro rata, and then they never used their pro rata.
There are a few ways for founders to minimize pro rata pain:
1) Get rid of pro rata in your funding deal. I’ve never tried getting away with this one, but a true gangster move if an entrepreneur pulls this off on an early round. Instead of the full gangster move, I have severely limited pro rata rights to very few folks, and generally apply a use it or lose it principle.
2) Do an insanely badass deal that scares off your current investors from participating in any major way.
We did this a few times at Uber. If you can get enough upside in future rounds, existing investors see less upside in exercising their pro rata rights, and actually get fearful that you’re over-valued and will sit out. I pitch this to new shareholders from the start, telling them before the round really gets underway, that the founders’ interest is that existing shareholders get as little pro rata as possible and ideally get none, and that I will do crazy sh*t to make that happen.
3) Get existing shareholders to vote away pro rata rights for the class.
We utilized this technique twice. Once was with seed investors when it came time for the Series A. One Seed investor was going to try to suck up and use pro rata rights from other shareholders not participating, and we used that desire to get other Seed shareholders to restrict certain provisions of the Seed class’s own pro rata rights – the pitch to non-pro rata-participating seed investors was that one shareholder was trying to unnecessarily dilute us.
4) Get existing shareholders to trade away pro rata.
There are a lot of other rights that investors like. Voting rights, Information rights, board seats and a whole bunch of other stuff. Bundle all the “special sauce” rights under the definition of Major Investor and make the definition successively more limited in each round. If you can get enough votes for the new deal, folks will be in a position to bargain for the rights they want, and you can offer them certain other rights if they get rid of their pro rata.