In an ever-changing dynamic world, the need to stay relevant and ahead of the curve is the key. Many companies wind up, and many new companies emerge. Have you ever wondered what it will be like to work on your dream project, starting a new venture that helps society to a large extent?
Your initial investors who believed in your vision and investors who joined you later by investing in subsequent stages are key to your venture. What if there is potential disagreement among different sets of investors? Pro Rata Right clauses and pro-rata convertible notes are such agreements that help settle the dispute of all stakeholders.
On that note, let us understand Pro Rata Right more deeply.
What are Pro-Rata Rights?
In the initial stage, as you build the prototype of your startup venture, you can mostly seek funds from friends and family. When your venture is a product ready, you can approach angel investors or venture capital firms for funding in the pre-seed and seed funding stages. As your venture grows in scale and magnitude, there are several layers and stages of funding, starting from Pre-Seed, Seed, Series, A, B, C, D, and so on. Have you ever wondered how the vetted interest of these several investors is taken care of and how their returns obligations are met?
Every investor in your business is given and earned certain rights regarding ownership and funding structure. As stated in legal terms, Pro Rata Rights is a right and not an obligation is given to investors. This right preserves the initial ownership percentage of the investors in subsequent financing rounds.
For example, suppose an investor initially agrees to inject capital for a 15% stake. In that case, the Pro Rata Rights allow the investor to participate in the next funding round, maintaining the initial 15% stake.
How do Pro-Rata Rights Work?
The concept of Pro Rata Rights works in tandem with the theories of equity dilution. You should note that the number of funds you raise in each funding round circumvents new equity or additional stakes raised. When a new stake or equity is raised, the stakes of your existing investors get diluted.
It thus jeopardized the situation of your current and existing investors, who are your initial investors, and hence the need for Pro Rata Rights is strongly administered. Your initial investors with Pro Rata Rights will maintain their stakes with veto power even in case of additional equity issuance.
For example, an EdTech company plans to raise Rs. 1,00,00,000 in its initial funding round. The company guarantees partial Pro Rata Right for all those investors who invest at least Rs. 50,000 and full Pro Rata Rights if Rs. 25,00,000 is invested in the first round. One investor invested Rs. 1,00,000 for 1% stake.
In the initial round, the company raised Rs. 1,50,00,000 and planned to raise Rs. 50,00,000 in the next round. In this case, the investor already owns 1% of Rs. 1,50,00,000, and hence the initial investment increases by nearly 50%. However, if the investor does not invest in the second round, he only gets to earn Rs. 1,50,000 out of the total Rs. 2,00,00,000 venture.
Why are Pro-Rata Rights Important to Investors?
Irrespective of the nature and size of funding, investors want their interests to be protected at all costs. The nature of the rights and the terminologies are well described in the pro-rata clause. It gives them assurance and the confidence to invest in your Startup venture.
Investors normally invest in a Startup seeking long-term potential and business model. These investments are illiquid, and investors earn a substantial return on investment when the venture goes public.
You should be aware of why Pro Rata Rights are important to investors
- Having pro-rata rights intact gives wealthy investors who invest in promising Startups the confidence to invest in subsequent rounds, ensuring their stakes are preserved.
- Many institutional investors have a pipeline of possible 20-50 promising Startup companies to park their funds. It helps them decide which among them would be profitable ventures for them to invest in.
- At times new investors wish that old investors should not participate in subsequent financing rounds. This conflict of interest is resolved and addressed through pro- rata rights clauses
- These rights serve as a reward for your early-stage investors. They trusted your vision and business model and invested funds into your Startup before it became a commercially successful venture.
Benefits of Pro-Rata Rights
Pro Rata Rights are a double-edged sword. There are both pros and cons of pro-rata rights. You should be aware that Pro Rata Right benefits investors greatly, but if these rights are not implemented and governed properly, they may backfire.
However, let us understand some of the advantages of Pro Rata Rights.
- Suppose you can steer your Startup as per the timeline, schedule, and structure, giving it a concrete shape. In that case, it will drive your investors to a profitable position securing a potentially more profitable exit.
- It keeps initial investors’ equity stakes intact, preventing it from diluting irrespective of rounds and magnitude of fundraising.
- You can negotiate the terms and conditions of the pro rata right with your investors before agreeing and signing the deal.
- It prevents conflicts of interest and safeguards the interest of both old and new investors.
How to Calculate Pro-Rata?
The important aspect is to know how to calculate Pro Rata Rights. The main idea and central theme of pro rata are that every intended party to the agreement gets their due share fairly and equitably without favor or bias.
To calculate pro-rata, you need to consider the following
- The number of funds raised
- The total equity stakes or propositional ownership structure
You can then use the following formula to calculate pro rata
The above working and formula will help you calculate and structure the pro rata agreement. You can negotiate the terms and conditions with your investors before they invest funds into your business.
Under what Circumstances would Investors Waive their Pro-Rata Rights?
In many past instances, investors have waived off their pro rata rights. You should be aware that investors generally tend to back out from Startups if they do not find them worthy of investing. Moreover, some of the stronger reasons why investors waive their pro-rata rights are as follows
- Shortage of Available funds: Many times, even though investors want to invest in promising Startups, they do not have the funds to do so then. Wealthy individual investors and angel investors often find themselves in such a situation. These investors may not have the adequate money to retain their stakes in further additional funding rounds.
- Faulty Projections: If investors find the projections of Startups faulty and questionable, they prefer not to participate in further funding rounds. Such a situation earns a bad image and reputation for the Startup. As the founder, and chief executive of your Startup, this is the last thing you want to encounter.
To tackle and counter this situation, you can rework a partial pro rata agreement with investors if a need arises.
Are Pro-Rata Rights Legally Binding?
Firstly, it is extremely difficult and time-consuming to pitch your Startup idea to potential investors and e adequate funds to start operations. In the first place, you are under no obligation to offer your investors pro-rata rights and vice versa. However, once you offer them pro-rata rights, you are legally bound to adhere to the norms.
In all situations, you need investors who would fund your venture and help you scale your operations domestically and internationally. Early investors believe in your vision and concept of your Startups, and later stage investors amplify your business by funding you at the growth stage.
All sets of investors are extremely important for your venture. However, the legally binding pro rata agreement solves potential litigation in conflict or disagreement.
As the founder or as the chief architect of your Startup you would probably want to spend more quality time with your core formulating strategies, developing your business model and plan, and captivating your research, advertising, and marketing teams. It is always advisable to take the help of an expert in a matter like designing and formulating the pro rata structure.