I don't agree with this, pro-rata rights protect investors from dilutionary events which they have no control over. I guess that's one-sided in the way that any "right" is in a legal contract, but that's a weird way to frame it.
It's also incorrect to frame the option as "free", you're only observing market behavior in a world in which the option exists, not one in which it doesn't exist. You can't say that investors would have the exact same behavior (in terms of prices, terms, etc) in a world in which they rarely or never got pro-rata. Maybe, but probably not.
Are you actually disagreeing with him, though? Pro rata is clearly a good thing for investors. But many founders just treat it as a neutral thing for them. I think and the author should both agree that a founder should slightly prefer the identical terms without a pro rata.
If founders keep this in mind, they might be able to get a better deal while negotiating. Yeah, investors won't act exactly the same way, but that's okay. Some investors don't care for pro rata rights, and those investors should be getting a slightly better deal in exchange.
>the author should both agree that a founder should slightly prefer the identical terms without a pro rata.
Framing in language like "prefer" is misleading the analysis of the situation.
The gp's point is there are unstated market forces of leverage that affects both sides ability to negotiate the terms they want -- but can't always get.
As other examples, consider "liquidation preference" or "50% ownership":
- Sure, a founder would "prefer" that there is no liquidation preference. But that preference is meaningless because investors won't invest money without it. Therefore the "unseen" alternate universe is the startup founder that convinced a hypothetical investor to pay millions with unprotected zero liquidation preference. Since that alternate universe doesn't exist, the current reality is that the investor has leverage on this term.
- An angel investor would "prefer" ownership percentage of 50% instead of 7%. But that preference is meaningless because most startup founders would not give up that much ownership because it's no longer worth it to build the company. The founder has leverage on this term.
Both sides want things they can't get.
Overlayed on top of this is shifts in leverage because of the balance of power between the available funds -vs- # of quality startups. If there's more money chasing the available startups with strong founders, they may have leverage to eliminate "pro rata". This wouldn't have been possible in the investing climate of 2008 when all VC funds got tighter with money.
I agree but then circumstances to defend against are pretty limited. Effectively a situation where a founder with control issues new shares at an arbitrarily low price to a new set of individuals. There has to be a more elegant tool to defend against that kind of event.
One thing not mentioned here is that for very tiny investors, pro rata is a right that can protect against aggression from later, more highly resourced funders.
If the company is scaling quickly, and looks like it could have a good return, a later stage investor could come in and cause massive dilution in the cap table by issuing many shares and granting some amount to the employees and founders. If I had pro rata, I could have a proportional share of the funding, and even if in the likely case I didn’t have the capital I could likely raise it, and at least get some share of the upside.
I was thinking of this myself. What protects against this except for pro-rata? I am a relatively ignorant bystander to the workings of VC but even I’ve heard it’s possible for dilution (and other adverse outcomes)to be counteracted for certain recipients by issuing new shares. Basically without pro rata and board control it seems you can “reset” the cap table at will?
Companies plus VCs do it to employees all the time too. You often get told in joining “you’re getting x% of the company with back of the envelope calculation if we sell for y that would be worth x% of y”, but few founders are honest about the whole “except for the fact that by the time we sell you’ll probably have been diluted in so many rounds that it’ll by nowhere near x%” part.
Especially if the company struggles and has down-rounds, and even more if the company introduces classes of shares with preference etc. they also generally won’t sign a contract that protects employees from that ever too, so you’re not at the negotiating table, you don’t provide any capital and the only reason they have not to completely screw you is if they want to retain staff.
Even if it’s looking pretty, the final round can involve a certain amount of mathematical trickery.
This is a ridiculous situation. Why would you possibly plow more money into a company that is actively adversarial against you?
If a company tries to screw you like this, you have shareholder rights. If you are a big enough fish that you are getting into crazy financing battles like this, then you are not the target audience for this post.
That's not necessarily the case here. When the investor in this example makes the initial investment, they are factoring in the possibility of failure and weighing that the compensation for this is the ability to participate in upside in the case of success. If they don't get a right of first refusal to participate in subsequent funding their upside is capped because a big investor will come in and want to take down the entire round (I have been involved in several funding situations and big investors very often want to do this in my experience). They will be left with a tiny stake and don't get to share in subsequent growth.
The whole VC ecosystem would change if investors knew on their losing bets they would take the full loss and on the winners their upside would be hard capped because they wouldn't be able to follow on. It would be much harder for companies to get funding in that world.
The thing is accounting for the risk and the lack of liquidity and opportunity cost I don't think it is worth coming to the table for most investors without pro rata. That's from my own calculations and some others posted here and there. Essentially, if you don't have pro rata or something equivalent to bet more on the winning horse the rational decision would be to place money in the stock or commodities market honestly with much less risk.
But yeah you should pick an investor according to what you want-- help and advice as part of the package is valuable and good investors and advisors give it openly.
Curious of course on feedback on this -- do other people get different numbers?
P.S. Maybe that is the idea for this post from someone from YC? Push away other future investors? :D
This seems odd to write, as [I believe] YC has one of the strongest, least-founder-favorable versions of pro rata. YC sets so many market terms for startups, they could change this dynamic.
Specific terms that offer pro rata re-assignment at YC discretion:
"Neither this Agreement nor the rights contained herein may be assigned, by operation of law or otherwise, by Investor without the prior written consent of the Company; provided, however, that this Agreement and/or the rights contained herein may be assigned without the Company’s consent by the Investor to any other entity who directly or indirectly, controls, is controlled by or is under common control with the Investor, including, without limitation, any general partner, managing member, officer or director of the Investor, or any venture capital fund now or hereafter existing which is controlled by one or more general partners or managing members of, or shares the same management company with, the Investor."
I think this is exactly why the post was written. Aaron isn't saying that YC has a great pro-rata program. I took his writing as stating that he thinks it needs to be reconsidered, and that it is bad as it currently stands.
Why? It has to do purely with the fund's internal structure. Affiliate transfers shouldn't have any material effect on a company. Withholding automatic affiliate transfers would be the company creating needless work for itself.
Honestly I'm a founder not investor, but one of the reasons that prices are so high is because of terms. Would I invest in a public company that may be overvalued (say Tesla) if I could get preferred shares, liquidation preferences, pro rata, etc? Yes.
So pro rata is just one in a basket of investor friendly terms.
It'd be really nice if articles like this began with a definition of the term.
Terms can often be ambiguous so this helps ground the article and ensure everyone is talking about the same thing. There are also plenty of HN readers who have no idea what it refers to that would also benefit greatly.
> Crazy! This is valuable term! Investors should have to pay more to get it
On the flip side, I'd love for a founder to give me a discount for agreeing to take out these boilerplate terms I have--as an angel investor--zero interest in adversarially leveraging.
I guess the founders would mostly argue that boilerplate is the price of admission for angels these days. But it would be great to see it work this way.
This is a very candid and transparent article and it is very good of Aaron to spell this out so clearly. It is possible for pro-rata terms to work out well for founders but more often than not it only works to the advantage of investors (because they have more capital by definition) and it stacks the deck against the founders in later rounds (and may make it harder to close a later round!).
It is interesting to me that the argument is over terms while admitting that "Contracts aren’t worth spit.".
Power and goodwill are what count.
However, contracts matter once outsiders start getting involved. The contract (hopefully) isn't there to bind the original parties much, but it matters a LOT once someone much more adversarial enters the picture.
so, he thinks you should have to buy pro-rata, and then have the later investors take it away anyway? and then the investor is expected to go to court over it? how long do you think investors that sue their founders will continue to get good deals?
yes, pro-rata is a bit of a pain on up rounds, especially in terms of letting later investors get the ownership they want. but on a down round, previous investors get wiped out very aggressively; they need the protection to be able to at least maintain their stake.
(personally, i will typically go with whatever the founder wants. "it looks bad if you don't take your prorata" or "i can't get enough room for the new investor" and so on. if a new investors adds terms to strip previous investors of their rights, i will insist on it, though.)
Hrm, overall I still lean toward pro rata being a net positive. The two situations this is advice is handling are these:
> I insisted on getting pro rata in tight rounds where the founder wanted to bring in new investors or limit dilution.
> I learned this through rough conversations with founders who expected a pro rata investment during a difficult fundraise and didn’t get it.
The 2nd situation isn't really something to protect against. To expect pro rata during a difficult fundraise is weird because the expectation is to be able to force someone to invest in your dying company? A non-situation to me.
The 1st one is the most realistic and understandable. Hot rounds really become a fight of letting the right people in at the right price. Without pro-rata small guys would disproportionately not be able to continue their investment.
So then it becomes negotiating with the incoming round's lead to lower post-money to avoid overall dilution.
Giving the previous investors an option to be in/out doesn't get anything for the founder.
If they 'want in' well, then they 'want in' and presumably, they'd 'want in' with or without the pro-rata.
What this means is that their position is guaranteed. If they 'wanted in' without the pro-rate, then the founder has more leverage.
Imagine you were trading options. Someone giving away options for free doesn't gain anything. The receiver of the options gains some material value, just in the option even if the strike price was the same as the current value i.e. options even.
You'd never just arbitrarily give away options on your company.
Now - there might be something to be gained in the relationship. It might just work out better with a fund, etc. to have that on the table.
But technically, no.
What would be interesting here is for someone to chime in on what the value of that option would be were it to be sold on the free market because we have methods for calculating those things.
It's something the investor wants to protect their investment. Compare e.g. getting warranties from the seller of a house - you could frame that as an option that you're getting for free and the seller should charge you for, but really without it you wouldn't want to make a deal at all.
One possible reason for pro-rata term that I don't see mentioned is preventing dilution due to an underpriced round. But since most of the time investors have to agree anyway to a new round that seems a minor concern.
Do you mean in a down round or just a round at a low price?
In my experience, any down round requires massive changes to ownership across the cap table, previous rights or not. The only way to stop this is with even more onerous terms that one doesn't normally see in VC term sheets.
This is very interesting and it strikes me that things could be more balanced if pro-rata rights decayed if the investor is not active.
So similar to vesting for rights — a founder / employee needs to continue to be active to continue to vest. Ideally an investor could continue to be active to continue to exercise pro-rata.
It’s pretty hard to enforce / codify “active” for an investor though and could just result in time wasting by pretending to be involved helpful when just coasting. Was that intro genuine or just designed to protect the pro-rata?
It seems to me that, without the pro-rata term, a founder could forcefully dilute an early investor by selling newly issued stocks at a low price to himself or his friends.
But the author doesn't indicate how that can be problematic.
How do existing requirement to allow previous investors in the round, contribute to a 'warping' or 'problems'?
I mean, if pro-rata is only designed to prevent dilution - well that should not be so bad. That means in any given new round, there should be enough room for new investors, no?
It also should be less painful in early rounds when investors own a smaller amount.
Completely agreed. Current pro rata rights are mostly a legal fiction that mostly harm founders with less experience or leverage. The right should be explicitly negotiated!
For those who aren't familiar with Pro Rata, the term isn't being well defined here or in the original post.
This site [0] does the best job explaining what Pro Rata rights are and why are they are important to both investors and their potential issues:
"Pro-rata right is a legal term that describes the right, but not the obligation, that can be given to an investor to maintain their initial level of percentage ownership in a company during subsequent rounds of financing.
In other words, if an investor with a pro-rata right initially acquired a 10% equity stake in a company, then he or she is given the option to invest more in the next rounds of the company’s financing to maintain a 10% stake.
...
The idea of a pro-rata right is essentially related to the concept of dilution. Each new round of equity financing implies the issuance of new shares. When new shares are issued, the percentage of the equity stake of current shareholders (founders, investors) is diluted. In other words, the current shareholders lose part of their voting power as calculated on a percentage basis.
In order to prevent such a scenario, the investors can ask a company to include a provision that grants them pro-rata rights. The investor with the pro-rata right is then able to maintain the percentage of their equity stake and voting power even with the issuance of new shares.
Note that the pro-rata right is not an obligation, and it can be exercised at the discretion of its holder. Some investors with pro-rata rights may opt not to exercise their option to invest in the next rounds of financing. The reasons for abandoning the rights include poor performance or development of a company, as well as extremely large additional investments required to maintain the initial ownership percentage.
In addition, in some cases, investors do not receive pro-rata rights. Some companies opt to grant such rights to valuable investors who have made a significant impact on the business.
Pro-rata rights are generally granted to, or asked for by, investors who invest in early rounds of financing. The investors are often not willing to exercise their rights in the later financing stages due to the high investment amount required."
As per above, the option to maintain the investor's initial equity is entirely up to the investor in subsequent rounds. However, this option is not afforded the founder. The founder is not able to maintain their ownership across rounds, because, for evident reasons, the equity that is granted to the investors necessarily comes out of the founders' shares. It has to add up to 100% (this can't be the startup version of The Directors).
One way I like to visualize this is like a growing pie. Like an actual pie, perhaps apple or blueberry, or pumpkin or chocolate silk.
In the beginning the pie is really small and can fit in the palm of your hand. It's all your pie that you and your founders can share. It's so small you can probably each eat it in one or two bites.
Now someone else is interested in your pie and contributes money (ingredients) to increase the size of your pie. They increase the size of your pie in exchange for 1/3 ownership. Now 1/3 of the pie is the investors to eat, and the other 2/3 is yours. You don't own all the pie anymore, but you and your founders can eat your portion of the pie now in two bites each. Hey the pie has grown for everyone, even if you share is smaller, your portion is more bites than it was before.
Now your pie is looking pretty darn attractive and someone else wants in. So a new investor puts in even more ingredients and really increase the size of the pie. In exchange, they take 1/3 of the pie. That shrinks your portion of the pie even further, and even that of the previous investor. The previous investor really likes your pie and they're not content with the number of bites they had before since the pie is so much bigger. They want more bites. So they chip in along with the new investors to keep their stake at 1/3 of the pie.
At this point, the founders have 1/3 of the pie, the first investors have 1/3, and the new investors have 1/3. The pie is much bigger, and everyone has many bites. In the beginning the founders had the whole tiny pie to themselves, and now they have 1/3 of a much bigger pie. They also have more people invested in the pie. It's not entirely your decision on what happens to the pie. Just hope it keeps growing so that when you sell your pie (assuming you haven't eaten it), it will go to someone who will buy that pie for more than the cost of the ingredients and all the time you spent on it.
It's also incorrect to frame the option as "free", you're only observing market behavior in a world in which the option exists, not one in which it doesn't exist. You can't say that investors would have the exact same behavior (in terms of prices, terms, etc) in a world in which they rarely or never got pro-rata. Maybe, but probably not.