Everything You Wanted To Know About Pro Rata (But Were Afraid To Ask)

Investors at Sequoia, Haystack, Homebrew, Initialized Capital, and Afore explain the surprisingly complex reality of one of VC’s least understood terms.

Afore
Afore
Jan 30 · 7 min read
Pro Rata can be the world’s most confusing pizza party. Here’s how to make sure to get your slice at the cap table.

Up until he first entered the venture capital game, Semil Shah, founder and general partner of Haystack, had never heard the two magic words of early stage investment: pro rata. And he’s not the only one, because those two words are some of the least understood ones in the VC dictionary.

What is pro rata? Simply speaking, pro rata is an option, not an obligation, granted to investors to maintain their ownership percentage in a company through future fund-raising rounds.

“Think of it like ordering pizza for a party when you don’t know how many people might ultimately be coming,” says Anamitra Banerji, co-founder of Afore Capital. “In that analogy, pro rata is a way for you to retain your share of cheese and pepperoni, even if more friends show up later”.

At first, pro rata seems straightforward. Early investors who take early stage risk, get the option to continue investing and maintaining their share of the company when the business has proven itself and started to grow. But pro rata is, in fact, a sometimes controversial subject among founders and investors, making it a complicated and stressful process to navigate.

To better understand the various aspects of pro rata, we spoke with:

Mike Vernal, Partner at Sequoia Capital

Garry Tan, co-founder and managing partner at Initialized Capital

Hunter Walk, Partner at Homebrew

Semil Shah, General Partner at Haystack

Here’s what they told us about how investors and founders alike should think about navigating pro rata, and what the future of pro rata looks like.

There are usually two types of investors who get pro rata: early stage investors like angels, and large institutional investors. Without pro rata, there’s a fear amongst early investors that they may be diluted by future investors out of the company’s division of ownership, called the cap table.

But the flip side of pro rata is that it often makes the cap table more complex to navigate across future funding rounds, and can risk diluting the company more than the founders might like. Again, for a simple analogy, think of our pizza: it’s much easier to split a pizza into equal slices than it is to guarantee across multiple helpings that a few people always get a specific percentage of the pie.

That’s why, amongst the investors we spoke to, many of whom were once founders themselves, there’s a feeling that pro rata shouldn’t be something you buy. It’s a privilege that should be earned. “The best investors earn pro rata by adding value to the company in ways besides capital,” says Garry Tan of Initialized Capital. And by earning that privilege, investors actually help protect themselves.

Because even though pro rata rights are granted often, fundraising situations may arise down the line where fulfilling all historic pro rata obligations can be difficult for founders.

“Revocation of pro rata rights often happens in later fundraising rounds because founders handed out pro rata willy nilly earlier, making the cap table too crowded. As newer investors come in with their own requirements and the cap table gets crowded, founders will oftentimes ask earlier investors to waive their pro rata rights for the good of the company,” explains Semil Shah of Haystack.

At Sequoia, Mike Vernal encourages founders to think long-term and optimize for maintaining flexibility. “It’s your company,” he says,“ and the cap table is one of the most important tools you have at your disposal for aligning the interests of founders, investors, employees, and advisors.”

“It’s your company and the cap table is one of the most important tools you have at your disposal…”

Founders can find themselves in uncomfortable territory when requesting early investors to step back from their pro rata because it’s something of real economic value baked into the price an investor paid upfront. But not doing so has its own costs, such as unravelling of an otherwise promising fundraising opportunity. Founders often have to choose between taking a potential reputational hit versus foregoing a high quality fundraise. It’s a tough choice, and that’s why some founders have mixed feelings about pro rata.

And reputational damage can go the other way too. “Right now, even those earliest investors with ‘rights’ can suffer reputational damage if they don’t waive them in situations when the founders ask,” explains Shah. Because there will be situations when asking early investors to give up their pro rata rights is the best thing for a company, and standing in the way of that is a short-sighted move.

“If investors give away pro rata to anyone who asks for it, they’re putting the loadstones on their back themselves.”

So what’s the best way to think about pro rata rights, when sometimes they aren’t actually enforced or exercised at all? Namely, it should be viewed as an earned privilege, gained and kept by an investor repeatedly demonstrating value to a company. And it is something that founders should grant investors only after careful consideration.

“It’s pretty simple,” agrees Hunter Walk of Homebrew. “Founders should only grant pro rata to investors who they know will provide ongoing value beyond their capital commitments. If investors give away pro rata to anyone who asks for it, they’re putting the loadstones on their back themselves.”

Even so, there will be times in a company’s life when a founder is pressured to ask early investors who have demonstrated their non-capital value to give up their pro rata rights. In such situations, what should a founder do?

The first question to ask yourself as a company founder raising capital, says Shah, is this: “Am I willing to re-trade that contract in order to establish a new reality?”

Yet all of the onus to compromise on pro rata or not shouldn’t lie with founders. “Investors should still recognize that there may be stages of the company where making all the puzzle pieces fit in a funding require some creativity,” explains Hunter Walk. And as a lead investor, one of your responsibilities is to help founders navigate a range of outcomes constructively… even if that’s against your short-term interests.

Which brings us to the question: given all of the reputational and institutional complexities, if you have pro rata, what’s the best way to exercise those rights?

At Homebrew, Hunter Walk says that as an early stage fund, they only exercise their pro rata rights for early rounds. “Part of our focus though is not investing heavily in their later stage/growth rounds, so you’ll typically see us start to pull back from pro rata in the Series C and beyond,” he says. “So we haven’t encountered major issues. Both the founders and new investors value our participation, because any venture investor who is willing to scuttle an attractive financing because of a few basis points of dilution isn’t someone thinking long term.”

At Sequoia, Mike Vernal says they don’t focus on pro rata. “Our north star is to be supportive of our partner companies throughout their entire journey. Sometimes, our growth team will lead a future round. If not, and the company is doing incredibly well, we will often write a smaller check to help accommodate new investors. If the company has hit a slow patch and needs more help, we will often write a larger check to support the company. We rarely think in terms of pro rata.”

There was a time when the only investors asking for pro rata rights were huge institutional investors. But with the advent of angels and pre-seed, more and more investors are being granted pro rata rights, setting up complicated cap tables and leading to potential future showdowns between founders and their earliest supporters.

Mike Vernal of Sequoia Capital believes founders need to maximize their ability to manage the cap table. “In most cases, if I were the founder, I would want to use each investment round as a way to thank those who have been helpful so far and create alignment with those who will be most impactful in the future.”

When it comes to pro rata, founders need to think more carefully about what early investors they grant the right to.

We here at Afore Capital agree. “When it comes to pro rata, founders need to think more carefully about what early investors they grant the right to,” says Afore’s Anamitra Banerji. The pro rata pizza party, in which everyone is vying for their slice, is slowly but surely changing, favoring founders and seed investors alike who think carefully about what pro rata means, and why it is granted in the first place.

Afore Mentioned

Afore Capital is a $124M Pre-Seed Stage Venture Capital Firm in San Francisco

Afore

Written by

Afore

Afore Capital is a pre-seed focused venture capital fund.

Afore Mentioned

Afore Capital is a $124M Pre-Seed Stage Venture Capital Firm in San Francisco

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