What are Pro-rata Rights?

You have likely stared at a term sheet and wondered about the long list of clauses designed to protect the investor. One of the most common and significant is the pro-rata right.

At its simplest level, pro-rata rights give an investor the option to participate in future financing rounds. It is not an obligation. It is a right.

The goal is to allow the investor to maintain their specific percentage of ownership in your company as you grow. If they own 10 percent of your startup today, pro-rata rights allow them to buy enough shares in the next round to still own 10 percent after that round closes.

Without this right, the mathematics of fundraising works against early backers. Every time you issue new shares to new investors, the existing pie gets cut into smaller slices. This is called dilution. Pro-rata rights are the primary defense investors use to avoid getting diluted out of a winner.

Let’s look at how this functions in the real world. You raise a Seed round and an investor buys 10 percent of the company.

Eighteen months later, you are raising a Series A. You are issuing new shares to bringing in a large venture capital firm. Because the total number of shares in existence is increasing, your Seed investor’s stake naturally drops below 10 percent. This happens automatically unless they take action.

If they have pro-rata rights, they can write a check alongside the new Series A lead investor. They purchase just enough of the new shares to bring their total ownership back up to that 10 percent mark.

This is often referred to as paying to play. They have to spend more capital to keep their position, but they are guaranteed the seat at the table if they want it.

While this sounds fair for the investor, it introduces complexity for you as the founder. You have to manage the allocation of your round.

When you raise a Series A, you usually have a target amount of money you want to bring in. You also have a new lead investor who likely has a target ownership percentage they require, usually around 20 percent.

Here is where the friction starts:

• The new lead wants a large chunk of the round.
• Your existing investors want to exercise their pro-rata rights to maintain their percentage.
• You only have so much equity to give away before you dilute yourself too heavily.

If you have too many early investors with pro-rata rights, they can crowd out the new capital. You might find yourself in a position where you have to convince early investors to waive their rights so the new lead investor can get the ownership stake they demand.

There is a psychological component to this as well. Because pro-rata is a right and not an obligation, investors can choose not to invest.

If an early investor has the money and the right to invest but chooses not to, what does that tell the new potential investors? It can act as a negative signal.

New investors might wonder why the people who know you best are declining to put more money in. Are they seeing red flags that the outsiders missed?

This is why founders need to be strategic about who gets these rights. It is common to limit pro-rata rights only to Major Investors, which is usually defined by a minimum check size. This prevents a cap table full of small angel investors from complicating future rounds or sending mixed signals.