Pro rata rights

A seed fund owns 10% of your company. Your Series A raises $20M at a $100M post-money valuation, so it sells 20% of the company. If the fund buys nothing, the round dilutes it to 8%. The fund wants to stay at 10%. A pro rata right lets it do that, and this lesson shows how much money it costs.

Predict first

The fund owns 10% before a $20M round at a $100M post-money valuation. How much must the fund put into the round to own exactly 10% after it?

Type a guess before you continue. A guess first, even a wrong one, makes the answer easier to remember.

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What a pro rata right is

A pro rata right is the right, but not the obligation, to buy part of a future round to keep your ownership percentage. “Pro rata” means “in proportion”: the investor can buy its own percentage of the new shares. The investor can use the right, use part of it, or not use it.

The right is in different documents:

• Priced rounds. In the NVCA model documents, the right is in the investors’ rights agreement. Usually only a major investor gets it, which is an investor above a set size. The NVCA model does not set the threshold, so each deal sets it, for example $1M.
• SAFEs. The YC post-money SAFE has no pro rata right. YC gives an optional pro rata side letter that lets a SAFE holder buy part of the priced round in which the SAFE converts. YC lets you give it only with capped SAFEs, and YC tells founders: “Please consider this pro rata right carefully.”
• Accelerator deals. The standard YC deal gives YC a pro rata right. The lesson on the YC deal explains it.

In the NVCA model, a major investor can also buy the shares that other investors with pro rata do not buy. This is the over-allotment.

The math

The pro rata amount is one multiplication:

Pro rata amount         = Ownership before × New money
                        = 10% × $20M        = $2M
If it buys nothing      = 10% × (1 − 20%)   = 8%
What $2M buys           = $2M ÷ $100M       = 2%
Ownership with pro rata = 8% + 2%           = 10%

The formula works because the investor buys its own share of the new shares. Before the round, it owns 10% of the old shares. It buys 10% of the new shares, so it owns 10% of the total.

Work it out

An investor owns 8% of a company before a $25M round that sells 20% of the company. What is its pro rata amount?

Your answerCheck

Why investors want it

A venture fund gets most of its return from a few companies. Thus it keeps reserves: money that it does not invest at first, so that it can invest in later rounds of its best companies. A pro rata right lets the fund put its reserves into a winner at the next price, before outside investors buy all of the round. The lesson on the power law explains why these few winners are so important to a fund.

The right also has a cost for the founders when the fund does not use it. If a large, well-known investor does not buy its pro rata, new investors can think that the investor knows bad news. This is signaling risk.

Pro rata does not cover the pool

The pro rata amount covers only the new money. But a round often adds a pool top-up and converts SAFEs too, and these dilute the investor. Northwind’s seed investors show the effect in the Series A.

Worked example · step 1 of 5

Northwind's seed investors in the Series A

1. 1

   Find the ownership before the round

   The seed investors hold 3,676,471 of Northwind's 18,382,353 fully diluted shares.

   Ownership before = 3,676,471 ÷ 18,382,353 = 20%

Show step 2Show all steps

The calculator below does the same math for a round that you set. Set a pool top-up, and the “To stay at” readout becomes bigger than the pro rata amount.

Calculator

Pro rata: the money to keep your percentage

An investor owns part of the company before a new round. See what it owns if it buys nothing, if it buys its pro rata, and what it must buy to stay level.

Investor's ownership before the round

10%

Fully diluted.

New money in the round

Pre-money valuation

$80M

Pool top-up in the round

0%

New options in the pre-money, as a part of the post-money.

Pro rata amount

$2M

10% × $20M

If it buys nothing

8%

With its pro rata

10%

To stay at 10%

$2M

Investor's ownership after the round

Buys nothing

8%

Buys its pro rata

10%

Buys 2x pro rata

12%

The investor owns 10% before the round. The new money buys 20% of the company ($20M ÷ $100M). If the investor buys nothing, it goes to 8%.

Its pro rata amount is 10% × $20M = $2M. That buys exactly its part of the new shares, so it stays at 10%.

Pro rata uses space in your round

Now look from the founders’ side. Each dollar that a current investor buys is a dollar that the new lead investor cannot buy. The lead is the investor that sets the terms of the round. Many leads want a set percentage of the company, so pro rata causes a conflict.

For example, your current investors own 30%, and all of them use their pro rata in a $20M round. They buy 30% × $20M = $6M, and the new lead can buy only $14M. Each allocation is a part of the same $20M. If the lead wants its full 20%, the round must sell more of the company:

Part that the round sells = Lead's target ÷ (1 − pro rata ownership)
                          = 20%           ÷ (1 − 30%)
                          = 28.57%

The founders now sell 28.57% of the company, not 20%. YC gives founders the same formula for SAFEs with side letters: if SAFEs with letters own 10% and the lead wants 20%, the round must sell 20% ÷ 0.9 − 20% = 2.22 points more.

Super pro rata makes the conflict bigger. A 2x super pro rata right lets an investor buy two times its pro rata amount. For example, an investor holds 12% before a $20M Series B. Its pro rata right lets it invest $2.4M. A 2x right lets it invest $4.8M, almost a quarter of the round.

Founder view

Pro rata uses space in your round

A new lead wants a part of the company. Your current investors use their pro rata. The founders own everything else.

Pre-money valuation

$80M

Part that the lead wants

20%

Current investors who use pro rata own

30%

Their right

Pro rata2x super pro rata

Who gives way

The round increasesThe lead gets less

Round size

$32M

28.57% of the company

Pro rata buys

$9.6M

New lead gets

20%

for $22.4M

Founders after

50%

56% with no pro rata

Ownership after the round

• Founders
• Current investors
• New lead

The current investors own 30% and buy their pro rata, so they buy 30% of the new money. To keep 20% for the lead, the round must sell 28.57% of the company, not 20%. It increases from $20M to $32M, and the founders go to 50%, not 56%.

How founders limit pro rata

Pro rata rights are normal, and they help you keep good investors in later rounds. But each right is a claim on a round that does not exist yet. A clean term sheet gives pro rata to major investors only, at pro rata, with no super pro rata.

Think carefully about SAFE side letters too. YC tells founders that pro rata letters can make the Series A bigger or increase the dilution. Slow investors can also stop the closing. YC gives two methods to limit them:

• Give letters only to SAFE holders above a minimum check size.
• Calculate the most SAFE ownership that can have letters. Divide the part that the lead wants by the largest round that you accept, and subtract the result from 100%.

For example, the Series A lead wants 25%, and you accept a round of at most 28%. The SAFEs with letters can own at most 100% − (25% ÷ 28%) = 10.7% of the company. If all your SAFEs own 20%, only about half of them can get letters.

Work it out

An investor holds 12% of a company before a $20M Series B. It has a 2x super pro rata right. What is the most money that it can put into the round?

Your answerCheck

Does the pro rata right count the SAFEs and the unissued pool?

The deal documents set the basis. In the NVCA model, the pro rata share uses fully diluted ownership. The YC side letter uses the investor’s percentage of the Company Capitalization, which includes the SAFEs as converted. Read the definition in your documents before you calculate.

Quiz · question 1 of 5

Test what you learned

An investor owns 8% before a $25M round that sells 20% of the company. What is its pro rata amount, and what is its ownership if it does not use the right?

• A$2M, and 6.4% if it does not invest
• B$2M, and the law makes it invest that amount
• C$5M, and it stays at 8% if it does not invest
• D$1.6M, and 6.4% if it does not invest