Recently I heard about a new investor strategy that I hadn’t seen before: as part of the term sheet, they asked for more pro rata rights than their ownership percentage. Pro rata rights mean that whatever percentage ownership initially purchased — say 10% — can be maintained when the startup raises more money in the future, assuming additional capital is invested to reflect the new percentage.
Here’s how it might work:
- An angel investor offers to put in $200,000 at a $4 million post-money valuation, to own 5% of the company but requires pro rata rights for 10% of the business
- Startup later raises $2 million at a $10 million post-money valuation, and the original angel that put in $200,000 now has the option, but not the requirement, to put in up to $600,000 (original 5% diluted to 4% by the new round but then 6% of the new business is purchased for $600,000) more money in the business and have 10% of the business, even though they had 5% after the previous round
- Startup now has a $10 million valuation and the original angel has put in a total of $800,000 for 10% of the business
The benefit for the angel investor is that they essentially get an option to increase their stake at a later time in the event the startup is doing well and decides to raise more money. In terms of downsides, the only challenge is that the entrepreneur now potentially has to sell more of their business in the second round of financing as many venture investors require a minimum ownership percentage for their initial investment (e.g. 15-25%) such that the entrepreneur might end up selling 35% or more of the business between the seed round and Series A (which isn’t uncommon). It’ll be interesting to see if this catches on for lead angel investors to ask for more pro rata rights than the original ownership percentage.
What else? What are some additional thoughts on more pro rata rights than ownership percentage?