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What’s the deal with prorate rights for startup investors?

In starting to raise a seed round I've heard some murmurs about prorata rights (the right to invest in us at a later stage to keep their percentage). It seems like a no-brainer to me to allow this. Is there any reason I wouldn't want to allow this? And where does the conflict come in with later stage investors?

5 Replies

Jacob Kojfman
2
0
Jacob Kojfman Entrepreneur • Advisor
Experienced technology and corporate lawyer, focusing on SAAS
It's more of a no-brainer for the investor as they won't get diluted. Reasons why you don't want to allow it: 1. Investors that do not have pro-rata rights will continue to be diluted so unless you have a solid shareholders' agreement/multiple voting rights for founders, founders may get diluted; 2. Larger investors that may come in may also want it; 3. Investors later may shy away from investing in you because their stake will not be as large as they expect it to be if previous investors exercise their pro-rata rights.
Jack Smith
1
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Jack Smith Advisor
Entrepreneur & startup advisor
potential disadvantage: it can often be a headache trying to fit everyone in to later funding rounds, as the pro-rata will often be significantly larger than the investor's initial investment.
John Kassebaum
0
1
John Kassebaum Advisor
PhD, PE, AC9JX
Hi David, It's not a bad idea and in Europe it seems to be customary. The only downside depends on how the right is forfeit or worked around for future rounds. If a future round were institutional or large, and the current investors have too much time to "decide" whether to participate or if there is a complicated process to get them to either exercise or wave the right - its possible that the term could be a complicating factor in the future round. I think if there is a reasonably short window of opportunity for the right holder to make a positive selection otherwise it is automatically waived, then it would be OK. Does that make sense? Of course, I am not sure how to structure this in writing - but I know it is done. Hope that helps! -John
Jack Smith
1
0
Jack Smith Advisor
Entrepreneur & startup advisor
@Todd I have no idea what you're trying to describe here. But that isn't really how pro-rata rights work.

you can read up here: http://avc.com/2014/03/the-pro-rata-participation-right/ but it has nothing to do with getting a future allocation at an "old valuation", that's not even possible from a tax perspective.
Richard P. Ashton, CSO
0
0
Richard P. Ashton, CSO Entrepreneur
Sales Process | Operational Optimization

The clause would need to be exercised to potentially have any effect on future investors. The only concern is future investors may want a percentage they are trying to achieve and would need to know the intentions of the "rights" hodlers before investing. Other than that, the sweetener simply means potential additional $ from committed investors. Interest from future investors, however, may also stimulate a "rights" exercise to maintain a percentage parity... it may also work in your favor!!!

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