Example Pro-Rata Participation for an Angel Investor

The post from two days ago Only Doing Seed Investments Without Follow-On Funding received a number of comments and questions. One aspect of being an angel investor that isn’t well understood is pro-rata participation in future rounds. As an investor you almost always get the right to maintain your percentage ownership if you invest more money each time the company raises money (this assumes an up round where the valuation is higher than the previous round). If you don’t invest more money with each subsequent round, then your percentage ownership of the company will decrease.

Let’s look at an example scenario for an angel investor over multiple rounds of financing:

• Angel investor puts in $25,000 for a company that raises a $1 million seed round on a $1.5 million pre-money valuation, making the company valued at $2.5 million, thus the angel investor owns 1% of the business
• Company makes great progress and raises a $3 million Series A at a $7 million pre-money, making the post-money valuation $10 million, and the angel investor has to write a check for $30,000 to maintain the 1% ownership (the $30,000 is part of the $3 million raise)
• Company continues to do well and raises a $10 million Series B at a $15 million pre-money, making the post-money valuation $25 million, and the angel investor has to write a check for $100,000 to maintain the 1% ownership
• Company is in super growth stage mode now and raises a $25 million Series C at a $75 million pre-money, making the post-money valuation $100 million, and the angel investor has to write a check for $250,000 to maintain the 1%
• Company goes public or is sold for $250 million making the angel investor’s 1% worth $2.5 million

Of course, this is an unusual and highly successful scenario (most cities are lucky if they have one success story of this size per year). In the end, the angel investor put in $405,000 ($25k + $30k + $100k + $250k) and earned $2.5 million (again, hypothetical). The key piece is that an angel investor who put $25,000 into a startup really had to put in a total of $405,000 to maintain that position as that’s the way to make the most money (by putting more money into the startups that are doing well). People that have $25k to put into a startup generally don’t have an additional $380k to allocate towards a single, illiquid startup investment. A general rule of thumb is to reserve 2-3x of all money invested in startups for follow-on funding. Pro-rata participation and potential dilution are important considerations for angel investors.

What else? What are some other thoughts on pro-rata participation for angel investors?