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The Pro-Rata Trap: How VCs Lose Millions on Their Biggest Winners
a newsletter about VC syndicates
Alex Pattis & Zachary Ginsburg
August 14, 2024
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The Pro-Rata Trap: How VC’s Lose Millions on Their Biggest Winners
Unfortunately SPV leads are occasionally unable to double down and get pro-rata on some of their breakout winners. This is an issue both syndicate leads and venture funds deal with and an issue that can have massive impacts on returns given the dilution from follow-on financings. Given the illusion of pro-rata rights and high (and often overlooked) impact from failing to invest in pro-rata rounds, we wanted to deep dive on the topic in this week’s issue. In today’s article, we’ll cover:
How pro-rata works
Reasons why investors sometimes DO NOT get or do not take their pro-rata
My personal view on how pro-rata actually works (not legally)
A few unique pro-rata stories that led to me getting pro-rata when we didn’t “legally” have it and losing it when we did
First…How Pro-Rata Works
Pro-rata rights give early investors the option to maintain their ownership percentage in subsequent funding rounds. It's like having a ticket to double down on your winners, but it’s not something you need to do.
Obviously not all of your portfolio companies are going to be winners where you want to re-invest and maintain your ownership percentage, but given a VC’s Seed investment may be diluted 50%+ from first investment to IPO, having a strategy around maintaining ownership, especially when acquiring ownership requires relatively minimal additional capital (e.g. Seed+, Series A), is critical to avoid leaving millions (if not tens to hundreds of millions) on the table in winners.
And when we say hundreds of millions, we mean it. As a quick example, let’s say Riverside acquires 10% of Company A at Seed. It turns out Company A goes the distance and IPO’s at a $3B valuation. If I maintained my full 10% in the business at IPO by investing in every pro-rata round (and thus avoiding almost all dilution), my stake would be worth ~$300M. If I skipped every pro-rata round, it’s likely I would have been diluted 50-70% and my take may only be worth $100M-$150M (i.e. $150M+ left on the table). Point being - pro-rata is serious money for the winners.
Here's what you need to know about how Pro-Rata works:
Initial Investment: A VC or Syndicate invests in a startup's early round, securing a certain percentage of ownership.
Pro-Rata Right: This gives the investors the option (not obligation) to maintain their ownership percentage in future funding rounds. It usually is only given to “Major Investors” albeit with exceptions.
Subsequent Rounds: When the startup raises more capital, the VC/Syndicate can invest additional funds to maintain their ownership stake.
Calculation: The amount needed to maintain the ownership percentage is calculated based on the new valuation and round size.
Decision Making: VCs & syndicates assess whether to exercise their pro-rata rights based on the company's performance, fund capacity, and overall strategy.
Fund Allocation: Many VC firms reserve capital specifically for follow-on investments to exercise pro-rata rights for 1 to 2 rounds of their breakouts. Syndicates really just treat it as a new SPV and a new investment opportunity as they are not managing capital via a fund.
Opportunity Funds: Some VCs create separate funds to capitalize on pro-rata rights in their best-performing companies. Again, this is not relevant to syndicates.
Negotiation: Pro-rata rights are often negotiated as part of the initial investment terms.
Partial Exercise: VCs may choose to exercise only part of their pro-rata right if they can't or don't want to invest the full amount. For syndicates, it’s often related to the 1) allocation we can get and 2) LP demand, so while pro-rata might be $200k, we typically end up investing what we can based on LP interest and allocation available.
Pro-rata rights are crucial for VCs/Syndicates because they allow firms to:
Maintain ownership in high-performing companies
Signal confidence to other investors (not relevant to syndicates)
Increase returns on their best investments
Avoid dilution via new issuance (i.e. new primary rounds - Series A, Series B, etc.)
Additional Note: exercising pro-rata rights can also present challenges, such as capital constraints and potential conflicts with new investors where you have founders trying to fit in new investors and their ownership targets. VCs must carefully manage their pro-rata rights across their portfolio to maximize returns. Syndicates also need to find the money even if they have pro-rata rights etc.
Second…Here’s why some investors do not get their Pro-Rata
Even though many early investors negotiate to get pro-rata, there are still many reasons why challenges present at pro-rata, and on both sides… Sometimes the VC lacks interest or capital in their fund. Other times the company is absolutely crushing and has so much demand to invest that it's hard for them to provide pro-rata and still take on the new interested investors (with percentage ownership targets).
Again, in general, pro-rata decisions are more complicated for VC funds than syndicates. We’ll share a number of reasons on why VC’s might not take or get their pro-rata below, but for syndicates, it really just comes down to:
Do we like the investment opportunity and want to reinvest?
Do we have allocation/pro-rata to invest more into this round?
Do we think our LP base will be interested?
For SPVs, pro-rata is treated as a new investment for one set of LPs and as a follow-on investment for another (e.g. the existing investors in the company).The previous LPs will all be invited to participate in the deal and reinvest to maintain ownership, however a new set of LPs that either originally passed or are new to the syndicate will also have the opportunity to invest here.
Here's an exhaustive breakdown of the most common scenarios a venture capital fund would NOT take pro-rata:
Capital Constraints:
The fund may lack sufficient capital to participate in the new round.
They might have already allocated their follow-on reserves to other portfolio companies.
Fund Lifecycle:
The fund may be nearing the end of its investment period or approaching liquidation.
New investments might not align with the fund's remaining lifespan.
Ownership Dilution:
New investors might negotiate for a larger stake, diluting existing shareholders.
The company may issue new shares for employee stock options, reducing overall ownership percentages.
Investment Thesis Misalignment:
The startup's direction may have shifted away from the fund's initial investment thesis.
The VC might not agree with the company's current valuation or growth strategy preventing them from following on.
Portfolio Strategy:
The fund may choose to diversify rather than concentrate more capital in one company.
They might prioritize other investments that align better with their current strategy.
Legal or Regulatory Issues:
There could be regulatory limits on how much the fund can invest in a single company.
Potential conflicts of interest might prevent further investment or if the company pivoted into another business that adds regulatory fund concerns.
Contractual Limitations:
The pro-rata rights might have expired or been subject to certain conditions not met.
New terms in the funding round might override previous pro-rata agreements.
Internal Decision-Making:
The investment committee might not approve additional investment for various reasons.
Relationship Dynamics:
Strained relations with the founders or other investors might influence the decision. Things may have taken place since the previous investment leading to new relationship dynamics.
The VC might be pushed out by new investors who want a larger stake → we see this happen a lot especially into the best performing companies.
Market Conditions:
Overall economic downturns might make the VC more cautious about follow-on investments.
Sector-specific challenges could reduce the attractiveness of further investment.
Opportunity Cost:
The fund might see better potential returns in new investments rather than follow-ons.
Fund Size Mismatch:
As companies grow, the check sizes required for pro-rata might become too large for smaller funds to manage.
Understanding these factors is crucial for both VCs and entrepreneurs, as it impacts capital availability, ownership dynamics, and long-term relationships in the startup ecosystem.
How pro-rata actually works (sometimes) → It’s Earned, not Given
So here is the thing. I don’t ever hear about investors suing their portfolio company for not getting their pro-rata, although I’m sure threats have been made in which founders may have caved. This is why I don’t always prioritize (for the most part) if we contractually have pro-rata or not. I know that more of the weight on getting my pro-rata down the line falls on my relationship with the company and the dynamic of the round. I realize this approach may be different for some.
This is why I feel that pro-rata is really earned and not given, especially at the earlier rounds. I have plenty of examples on both sides where I don’t contractually have pro-rata but I get it, and also where I do contractually have pro-rata, but we’ve been squeezed out due to a competitive next priced round.
Was I going to take legal action with my portfolio company? Of course not.
I don’t really ever hear of this happening. I’m sure there are some behind the scenes scenarios that lead to a bunch of friction across founders and investors, but I never heard that anyone actually took legal action in the early rounds. That investor would have a tough time defending their “founder-friendly” brand.
Whether you’ve got pro-rata or not, when it comes time where the next round is being put together, and assuming this is a competitive round where not everyone gets an opportunity to re-invest or their full pro-rata, it really is up to the founder to decide allocations. So, being helpful to the founder or being friendly becomes important here.
This is especially true for syndicates. Sometimes the flexibility in our check sizes or the fact they are smaller versus institutional can be an advantage here as it might be easier to fit our smaller check size in. Not always the case, but if you are in touch early with the founder as they are piecing the round together, it certainly can play to our benefit.
Below are some examples of unique situations that took place in various pro-rata rounds.
#1 → Pre-Seed to Sideline
We met a company pre-seed that we really liked and co-syndicated the deal with another syndicate lead we work with on occasion. There was no institutional capital in this round as it was a small pre-seed. Since that pre-seed round, the company has gone on to raise 3 new funding rounds at significant markups and from top tier VC’s. Unfortunately we have not been able to participate in any of those funding rounds despite having pro rata rights. We were able to do an uncapped note after a previous round but that was it. Yes, I’m extremely frustrated to have been a very early investor without the opportunity to re-invest at the follow on rounds given the company seems to be executing on all cylinders. To my point, you need to ensure the founder wants you in the follow on rounds as they are the decision maker and unfortunately in this one, we’ve been sidelined since the pre-seed where we were (I think) the second largest investor.
Side note → most founders would be more communicative than these ones, so it does show character, but one could also argue we did not add any value besides capital here and therefore did not earn our pro-rata position.
#2 → YC SPV grind to sitting on the sidelines
A GP friend put together an SPV for a YC company while they were in YC. He liked the company and the opportunity but it really had no signal at the time and presented a very tough SPV raise to ultimately get ~$80k committed to invest. The round itself was a tough one for the founders as they did not generate enough visible traction to help move the round along. Since that raise, the company found tier footing and has gone on to raise major up-rounds in both series A and series B in which they were unable to participate in. Their Seed investment is likely already diluted 30%+ from a lack of pro-rata participation.
#3 → No allocation left but let’s get creative
I invested personally in a pre-seed round in 2019 and became pretty friendly with the founder. 1 year or so later, the company pivoted and raised a solid seed round. Fast forward a bit later ( I also introduced them to a key exec hire ahead of series A), they ended up getting a $25m term sheet for series A from a top firm. This was a ~20x markup before dilution from my angel check.
To no surprise, the round was competitive and pretty much all investors wanted to take their pro-rata in this priced round. I think some institutional VC’s got pro-rata and some did not, which is how it goes in these rounds. The founder really wanted to get us some allocation and was also really appreciative of our support and intro to key hire, so he was able to allow us to get a few hundred thousand in secondary to squeeze us into the fundraise despite us having no formal pro-rata.
Again, this is not typical, but an example here of how founders will go to bat for you if they feel the need to. I was very appreciative here!
#4 (Written by Ben Zises of SuperAngel) → The Previous Lead “Waived” our Rights
Unless you are both (i) the largest and (ii) the lead investor from the prior round with contractual voting and control rights in a company, Pro Rata is, for the most part, bullshit.
When I started angel investing, like most people, I did not know any of this.
For example, in one case, while I formally had "pro-rata" rights to follow on in a Series A financing of a company to maintain my ownership stake, those rights were unknowingly at first to me, "waived" by the larger lead investor from the last round who controlled shares of the same class as me. As such, when they agreed to "waive" their pro-rata rights, all other (mostly smaller) shareholders that held those same rights were impacted just the same.
This was extremely frustrating. I had been planning for maybe a year leading up to that Series A round, knowing it was a likely scenario, by putting aside money so that I could continue investing in the company.
And, while I was incredibly upset, angry and disappointed at first - even considered making a formal complaint to the founders, the lawyers for the company patiently educated me on the reasons behind the decision that the lead investor made to "waive" their pro rata rights, and why it might just be, in the best interest for both the company and ALL existing shareholders.
In this case, what I eventually learned was that the lead investor did this to let the company bring in a handful of extremely strategic and valuable 'celebrity investors,' who, in exchange for investing, were going to actively promote the company to their audiences at no additional expense. And, since this was a consumer brand, having those celebrities as essentially unpaid influencers and PR machines, carried enormous value in distributing the brand's message and driving sales. Once I learned this news, of course, I agreed with the decision but still did not love the fact that while I seemingly had this particular "right," it was taken away from me entirely without my permission.
Fortunately, as a workaround to invest more into the company, I ended up learning more about secondary transactions and eventually found a way to acquire shares from a few other existing investors via a company-approved secondary transfer.
Lesson being: as an angel investor, or anyone other than the majority shareholder of a given class of shares, while you may technically have pro rata rights they are able to be taken away from you for reasons entirely out of your control.
And so, I never ask a founder to sign a pro rata side letter with me.
Instead, I try to be as helpful as possible for a founding team and their company, attempting to make myself as valuable as I possibly can to them, so whenever a time comes where I want to acquire more ownership in their business I have built up a bank of social capital. And as a result, over the past 10 years investing $20m into over 100+ companies, I can only count on one hand the number of times I wanted to invest more into a company than what they were able to provide me. As Naval Ravikant say's "The best way to build a brand in this business is to help other people." And that is precisely what I have been doing for the past 10 years, and what I plan to do for the next 10.
Summary
To wrap this up, let’s talk about why pro-rata is so important from a portfolio level.
Venture capitalists who lean in and re-invest in their breakout portfolio companies are positioning themselves for outsized returns. By doubling/tripling down on their winners, VCs/Syndicates can increase (or hold) their ownership stake in companies that have already demonstrated market traction and growth potential, effectively doubling down on their most promising portfolio companies that have a chance to be fund -returners or outsized returns, and make up for the losers in the portfolio. This not only allows them to capture more value as these companies continue to scale but also sends a strong signal to other investors (more so for the VCs than syndicates) and the market about the company's prospects. As mentioned in the example at the top - NOT having a follow-on strategy can be costly; in the nine figures costly…
Moreover, re-investing in breakout companies enables VCs/Syndicates to stay closely involved in the company through later stages of growth. By leaning in to follow on rounds, investors also protect themselves against dilution in future rounds, ensuring they retain a meaningful stake in what could become the standout performers of their portfolio - the outlier companies that often define a fund's success and drive returns for limited partners.
If you enjoyed this article, feel free to view our other posts on investing strategies and rights:
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Sydecar empowers syndicate leads to manage their investments more effectively. Organize, manage, and engage your investor network effortlessly with Sydecar’s management and communication tools. Their platform also automates banking, compliance, contracts, tax, and reporting, freeing up syndicate leads to focus on securing deals and strengthening investor relations. Elevate your syndicate operations with Sydecar.
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