Nature and Scope of Pro Rata Rights
Pro Rata Rights are rights that grant investors the ability to maintain their proportional ownership in a company after future funding rounds take place. These types of agreements are most commonly associated with equity investments, and they typically stipulate that an investor has the right to participate in future financing on a pro rata basis in order to maintain their percentage ownership in the company. In simpler terms, if a company is raising another round of funding, a Pro Rata Rights Agreement allows its existing investors to purchase shares (stock or a convertible note) proportionate to their existing equity in the company .
For example, let’s consider a hypothetical scenario: George just invested $100,000 in a Series Seed round for a startup and the company is now currently worth $1M. So with his investment, George owns 10% of the company. The company raises a $1M Series A at $5M pre-money valuation. This time, George would like to invest another $50,000. Without Pro Rata Rights, George would own 2% for his $50K (at a $5M valuation). With Pro Rata Rights, George can buy in for a total of $100K more per the terms of his original Pro Rata Rights Agreement, maintaining his current percentage of 10%.
Essential Elements of a Pro Rata Rights Agreement
A pro rata rights agreement is a legal document that dictates the terms and conditions under which a company’s existing investors can maintain their proportional ownership in future fundraising rounds. In this section, we’ll delve into the key components that are critical in shaping the contract and protecting both the investor’s and the issuer’s interests.
**Terms and Conditions**
These elements are crucial for defining the contractual relationship between a company and its investor. A pro rata pro rata rights agreement generally contains the following:
a. Obligations of the Issuer
The issuer is generally obligated to keep its existing investors informed of the impending financing round, setting forth the following:
o number of shares to be issued;
o aggregate purchase price;
o purchase price per share;
o nature of all other considerations if any;
o form of payment (cash or other consideration); and
o closing date, which may include an anti-dilution protection mechanism (explained below).
b. Obligations of the Investor
The investor generally is obligated to respond within a specified period of time and subscribe for an amount equal to its percentage of ownership in order to purchase the same percentage of shares as purchased by the other purchasers in the offering. The agreement generally defines the notice requirements and method of delivery, including the necessary address and person to whose attention the notices are to be delivered.
c. Anti-Dilution Protection
To avoid the risk of dilution, many pro rata rights agreements contain provisions that allow the investor to subscribe for additional shares in a subsequent offering per the price basis formula:
Example 1
Assuming the investor has a pro-rata right with respect to future offerings of stock in the company and currently owns one million shares and 10 percent of the company. Additionally, assume that a new investor is purchasing two million shares in the next financing round for $50 per share.
If the investor does not control the agreement, then to maintain its 10 percent ownership of the company, it would need to buy an additional 100,000 shares for $5 million (10 percent of two million shares).
However, the investor may get dilutive protection against exercising its pro-rata right. For example, it could set its purchase price to the average of the value of each share after the first financing and before the second financing (the "anti-dilution price"). Assume that the investor set the anti-dilution price at $20 per share. In this case, the investor would have the option to purchase two million shares at the anti-dilution price of $20, which would be $40 million.
Advantages of Pro Rata Rights for Investors
Pro rata rights agreements provide several advantages to investors who opt to participate in the capital-raising process. Perhaps the most obvious benefit of pro rata rights is that they allow investors to maintain their level of ownership in the company by virtue of the right of first refusal on additional rounds of funding. In addition to preserving a stake in the company, pro rata rights also afford existing investors the opportunity to weigh in on which upcoming rounds they want to buy into. A country club may give a member an option to buy into eight rounds during the course of a year, allowing them to decide on whether the fifth one is a good opportunity, whether to wait until the eighth or even decline to invest in any of the rounds.
If an investor has invested in the company from the beginning, they will be in the best possible position to know about the company’s needs when it arises and can then make a better informed decision to invest. Another advantage of pro rata rights are that, by keeping its existing investors invested in the company, the company working to attract other new investments by demonstrating a loyal base of investors who have stuck with the company over the years. This might be particularly important for tech companies and the ever-accelerating pace of investment and innovation, where new opportunities come up in rapid succession, and the company needs considerable capital to implement new ideas. It is like a race between horses and their jockeys, and if one horse’s jockey bows out, another jockey can step in and take over.
For example, Facebook came to its first financing round as a college student with a 1.6 percent ownership stake in the organization. In order to retain a similar percentage of ownership interest in the company, that college student turned investor would have had to invest $42,600 over each subsequent round. Ten years later that little-known college student bought in for the last time, investing $15 million, which gave him a 0.2 percent ownership share in the newly public company. Although only 0.2 percent ownership interest in a publicly traded company could seem quite slight, the immense increase in value that $15 million brought in over 10 short years is enormous.
Negotiating Pro Rata Rights: A Practical Guide
When negotiating a pro rata rights provision, the investor will usually want to get as many rights as possible for a given investment (such as the right to purchase its proportional share of a subsequent offering or an offering that includes a "major investor" right of first refusal). To negotiate successfully, the investor should be strategic about deciding what rights to request. For example, if a current investor is acquiring 20 percent of a company’s equity in a Series C financing, it may be more strategic to request pro rata rights in that round and in future rounds based on its pre-financing percentage, rather than based on its percentage post-financing (assuming it’s not getting a board seat). While these options would likely give similar results mathematically when predicting the company’s size over time, requesting a pro rata right to future rounds based on the pre-financing percentage can have a larger impact in the event of a down round, where an investor’s post-financing percentage could be diluted more heavily. Investors may also want pro rata rights to a company’s future "C" or "D" financings with rights of first refusal for future financings.
Companies, meanwhile, will want to keep the pro rata provision as limited as possible. For instance, investors will frequently request that the pro rata right apply to future financings but not to other issuances of shares outside of financings. A company may want to limit this type of right by specifying that it applies only to exclusive financings and minor financings and not to issuances to company investors as part of the purchase price for the acquisition of a company, for employee inducement compensation plans, or as a result of preemptive rights.
Another area of contention can involve the time period of a pro rata right of first refusal. Depending on how the company’s securities are structured, the investor and the company can be at odds over this as well. For example, a corporation typically can have both preferred stock and common stock outstanding. Because preferred stockholders have a right to dividends before common stockholders and because potential sales of a company often provide preferred stockholders with liquidation preferences, any dilution or anti-dilution calculations should be done with respect to each class of stock separately. However, pro rata rights typically extend from one class of stock to another, meaning that, at first glance, the corporation may be required to offer its preferred stockholders rights to participate in offerings of common stock, and vice versa. For this reason, the scope of pro rata rights is key to a deal involving multiple classes of stock.
Potential Pitfalls and Risks of Pro Rata Rights
Pro Rata Rights Agreements can present buried land mines for the unwary. For instance, pro rata rights agreements may contain complicated and confusing terms that are not well understood by lawyers or investors alike. Pro rata rights may also be ill defined and therefore not properly exercised. And pro rata rights may be poorly documented and open to dispute. Finally, pro rata rights are subject to dilution and adjustment rights, which create ambiguity for the investor and lead to disputes with other investors and the company.
Pro Rata Rights are often governed by contractual terms, and disagreements can turn into expensive legal battles to resolve the definitions or enforcement of pro rata rights. For example, an investor may believe its pro rata rights have been violated because it was not included in a distribution and the documents and communications do not clearly define the triggering event or the investor’s rights or remedies in the event of a trigger. Also, pro rata rights may be violated by the acceptance of a failing seed-stage company in a down round, or by an otherwise business savvy angel neglecting to exercise pro rata rights in connection with an up round of financing.
Pro Rata Rights are Not Absolute: The Definition of "Common Share" May not Include Common Shares Issued to Non-Authorized Members of an Issuer Cap Table
Most early stage investment documents provide that a dollar amount of capital investment will buy a certain number of common shares of an issuer, and that the pricing per share may change in the future if the issuer’s business is not at a certain maturity stage. The right to invest in subsequent rounds of financing on an equal economic basis with initial investors (i.e., a pro rata right) is an important antidilution measure for the investor against hard times. An investor may expect to continue to round up its ownership interest over time under a pro rata rights agreement, and come to rely on the expected value of these investments going forward as intrinsic shareholder equity.
A good example is an experienced investor with a significant ownership stake in an early stage, rapidly growing technology company. This investor is a group of interconnected angel funds or groups, and has the right to invest pro rata in all subsequent rounds of financing for a certain number of years. In anticipation of the next round of institutional financing , the investor informs the lead investor in the next round that it desires to exercise its pro rata rights.
The private equity attorney representing the issuer may inform the investor that the capital table now includes a number of different classes of common shares. "Common Share" is defined to mean any class of common shares, but the original terms may have been written prior to the introduction of the category of shares. "Common Stock" is defined as "including the Common Stock of the Company and any and all other equity securities of the Company, including Series X-3 to Series Y-5, and any class or series containing a right to convert into or exchange for Common Stock by operation of law, contract or otherwise." The term is included in various places throughout the document describing the rights of shareholders. The lead investor is unable to determine whether the pro rata rights are properly exercised based on the definitions of "Common Share" and "Common Stock." The absence of adequate contractual terms leads the lead investor to conclude that the pro rata rights are revoked. Disputes and considerable expense ensue.
Pro Rata Rights May Be Revoked and May Be Made Subordinate to Other Rights
Another example is when an investor completes its initial investment and elects not to retain its investment rights for subsequent rounds of financing. The investor may then go out of business or fail to retain an adequate track record with its LPs. A followed-on investor may then decide that the pro rata right is inadequate for the new round and refuse to take the initial round investor’s pro-rata share of stock at the exercise price provided in the first investment. Bondholders or preferred shareholders may also make pro-rata or anti-dilution demands on a company, thereby diluting the common shares or the pro rata rights of other shareholders including the initial investor.
In Conclusion, Investors Need to Understand the Definitions and Mechanics of the Pro Rata Rights before Entering into the Contractual Relationship
Investors that want to contractually retain pro rata rights should ensure that the investing documents adequately and explicitly detail the definitions and scope of the rights and any associated risks.
Legal Considerations and Best Practices for Pro Rata Rights
When a pro rata rights agreement is entered into, it should be understood that some control over director appointments may have been conferred onto the rightsholders, as the agreement may prevent the targeted company from appointing board members that are perceived as competitors. If a pro rata rights agreement is drawn up, it is necessary that a wide net is cast to include all issued and outstanding securities, defined as common equity interests of every kind. In other words, pro rata rights should not be limited to common stock, as then dilution of options, debt, and convertible securities would not be considered when evaluating the pro rata equity stake needed for new stock issuances. It is important to stick with the language of "pro rata" and to avoid referring to "fully-diluted" or "fully diluted" bases in order to make this expressly and properly applicable in the event of future issuances of equity securities that are not options, debts, or convertible securities. A pro rata rights agreement that limits holdings to only common stock could lead to complications down the line (e.g., when a venture-backed company begins hiring a significant number of employees and shareholder dilution increases). Since the majority of investors would exercise options and convert convertible securities, as well as purchase more equity securities in future rounds, specific language with respect to all equity interests should be used to alleviate this concern completely. Pro rata rights agreements require that the rightsholders must continue to put up capital relatively proportionately when the targeted company goes out for their next round of financings, but the rightsholders may or may not actually do so in the end. Although the obligation to continue ownership amounts to an agreement, the decision to actually invest is a voluntary right only. To avoid being squeezed out, a rightsholder must ensure careful planning when entering into the contract so as to be able to act. It is highly recommended that if an investor is first approaching the target company as an outside investor, the pro rata agreement be negotiated and finalized in advance of the investment terms. In most instances, this is better than implementing the pro rata rights after the initial round has been secured with minority interest shareholders and without establishing any majority shareholders.
Comparing Pro Rata Rights with Other Investment Rights
Pro rata rights are related to but not identical with other types of investment rights. These include preemptive rights, which typically allow existing investors to subscribe for additional securities of a company in order to maintain their relative ownership positions if the company decides to issue new equity securities, and anti-dilution rights, which give an investor the right to purchase additional equity securities in order to convert some or all of its shares of preferred or convertible preferred stock into common stock when there are dilutive effects upon such preferred or convertible preferred stock. Typical anti-dilution provisions specify that the investor has a right to buy additional shares of common stock at a reduced price in the event the company later sells them at a price lower than the original investor paid.
In contrast to these rights, pro rata rights simply allow the investor to maintain its percentage ownership of the company over time. Pro rata rights do not include the concept of piggyback registration rights , which normally entitle a holder of securities to a company’s registration of any of its own securities, either on a registered offering or a secondary offering of employee stock options if permitted under Rule 701 of the Securities Act.
In some cases, pro rata rights may not be available under certain complex or lead investments, such as in a participating preferred investment. A participating investment typically provides investors with a preferred return on their capital, plus participation in the upside of the company up to a specified return on their investment. However, because of that potential return, there can be no pro rata right and no right of first offer for existing investors. The preferred issuer of participating securities typically has no obligation to give notice to the company enabling it to exercise its pro rata right. Other investors should make their pro rata and right of first offer decisions on their own without notice from the issuer.