I was talking to one of our investors the other day about our upcoming fundraising when told me his firm wants to participate in this new round “super pro rata”. It reminded me of all the funny MBA-speak we have in the Internet startup world. So what does he mean by super pro rata and is that a good thing?
There are two answers to this question, but let’s define pro-rata before we talk about super pro rata. It is extremely common for investors to have “pro-rata rights”, or the right to maintain their percentage ownership in a company in later stages of financing. So, if Accel invests $1M in your first round in exchange for 20% of your company they have the right to keep that 20% ownership in subsequent rounds of financing by investing more money. Incidentally, your company is now worth $5M ($1M is 20% of $5M) after the financing or “post-money.” Let’s say you raise $10M in your second round of financing. Accel needs to invest $2M in that round just to keep their 20% ownership stake, which leaves 80% of the financing to new investors. So let’s say these new investors are also buying 20% of the company for this new $8M. This means your company is now worth $40M ($8M is 20% of $40M) post-money. That means Accel owns 20% and the new investors own 20%, for a total of 40%, and both investors have the right to keep their 20% stake going forward. While Accel had to pay up to own exactly the same percentage of the company, their 20% is now worth 8x their original $1M investment or a whopping $8M. Not a bad return, but it’s only on paper right now so don’t get too excited.
Now, let’s look at where super pro rata comes into play. There are two different ways super pro rata is used. One is super good and one is super bad:
- Super Pro Rata – If Accel wanted to own more than 20% of the company in the second round of financing then they would want to participate “super pro rata”. Simply put, they want to own their pro rata percentage of 20% and they want a piece of the other 20% the new investors are going to own with additional $8M investment. Presumably, they want to own more because the company is doing well and it’s smarter to invest more money into something you know is getting traction rather than to invest in a new, unproven company or concept. It is ultimately up to the founders to let investors own more than their pro rata in subsequent rounds. When an existing investor wants to participate super pro rata, it is a good sign and it sends a positive signal to other investors that things are going well since existing investors have the most information about a company.
- Super Pro Rata Rights – This is when an existing investor adds the contractual right to buy more than their pro rata share in subsequent rounds into the term sheet of the first found of financing. It might seem like a subtle difference, but wanting to own more and having the right to own more are very different. Plenty has been written about why super pro rata rights are bad by Mark Suster, Brad Feld and David Beisel. Net-net, this is bad because it significantly reduces your options for new investors in subsequent rounds, which drives the valuation of your company lower and reduces your chances of getting funding at all. As Mark points out, if the investor that has super pro rata rights exercises them, then there might not be enough room in the round for new investors, so they get to name their price. If they have super pro rata rights and don’t exercise them, it sends a red flag to new investors. Basically, you’re damned if they do and you’re damned if you don’t, so don’t do it!
So, to sum it up, super pro rata is super good, super pro rata rights are super bad.
28 more posts to go in my 30 posts in 30 days challenge, so stay tuned.