How to Read Pitch Deck. Pro Rata
The investment story does not end with one single cheque. In the future, the investor may be threatened by the loss of his share in the capital. However, this can be countered.
Every successful startup sooner or later attracts new investment. Great joy for the founders of the company is accompanied by some worry on the part of the initial investors. The fact is that as a result of the influx of new money, the original investor’s share is diluted. Here you owned 10% of the stock, and now it has turned into 7%. The pro rata mechanism was invented to help investors even out that number, and this material is devoted to it.
Many thanks to Daryna Koval, investment analyst at TA Ventures, for her contribution to the text.
Why do we even need it?
Pro rata is a regulatory mechanism that allows investors to keep their shares during new rounds. In practice, it looks like this: an investor buys additional shares of a startup to save the initial piece of the pie from being eaten by others. As we can see, the phenomenon is not free and requires additional money. Imagine pro rata in the form of a portion of shares reserved by the startup specifically for you.
To keep one's share or not is purely voluntary. Pro rata is a right and not an obligation. If necessary, you can give up. However, please note that this option is only available if there is an initial agreement between the investor and the startup. The terms of pro rata are written in the Term Sheet, Shareholder Agreement, or Investment Agreement. If your lawyers forgot about this nuance, well, don't make the same mistake in the future.
Investors in early-stage startups are most susceptible to share dilution. By investing relatively little money, the investor gets a good share, but the risks at the early stages are also high. The further the startup progresses, the more money it will need. The emergence of big players with large sums of money is fraught for the original investors with the risk of being left out. Not fair, is it? Pro rata acts as insurance.
Here is an illustrative example of all of the above. Joe invested in startup X at the seed stage. As a result of the investment, Joe owns 500 shares out of 5,000, which corresponds to a 10 percent equity stake. Next, the startup decides to raise more investment and participates in a Series A round. This brings in 1,200 new shares, and Joe's stake is diluted. We do the math: 500/(5000+1200) = 8%. Two percent less than it was!
Joe has two options. He can participate in a new round and pay extra to keep the 10% level, or he can do nothing and be satisfied with 8%. This is an important point for an investor. A good startup won't stop at a Series A round. There will be others, which means Joe's share will erode even more. At this rate, the investor who owned 10% may only get half in the event of an exit. That's a shame.
Two Towers
Pro rata is primarily of interest to investors themselves. For them, it is a tool for preserving the necessary percentage of shares in the long term. But startups do not like pro rata because it limits their ability to attract new investors.
New investors mean not only money, but also expertise and connections. The stagnation of the same participants in the capital can lead to the deterioration of a startup's performance. Fresh blood is needed. On the other hand, pro rata serves as a carrot for investors in the early stages, when finding money is difficult. However, inefficient use of this tool can lead to a dead end.
Imagine a situation where a startup offers pro rata rights en masse. As a result, investors hold significant stakes and are not going to part with them. If a fresh round of investment is raised, new players either will not be able to enter the company or will not want to. The reason is the same: there is no room. Some will not fit, and others invest only in large cheques, which leads to the same outcome.
In this mess, the startup is in for some tough and unpleasant negotiations with the current investors. They may agree to dilute their shares. Otherwise, the founders of the company will be forced to sacrifice their part in the capital. As we can see, everyone will lose.
A startup needs to know how to balance and not give away the right of pro rata to everyone. In the future, this can play a cruel trick. Conclusion: keep a good mix of investors. This approach is attractive to everyone involved in the deal.
Beacons
Experienced investors use pro rata to evaluate the prospects of a startup. This term is considered the second most important in a deal agreement, after the company's valuation. The fact is that the current investors' rejection of pro rata rights may indicate problems within the company. If the startup is so good, why isn't more money being invested in it? This could discourage potential deal makers and undermine the credibility of the company.
At the same time, voluntarily agreeing to dilute stakes may mean nothing at all. For example, the investor has reached the desired level of diversification in the projects. Another option is that everything that was planned was invested in the startups. To solve these puzzles, you can turn to detectives. As a last resort, ask current investors directly.
Situation tasks
Let's reinforce the material with a few more examples. Two founders decided to launch a startup called Turbo. The company is engaged in unmanned sandwich delivery in San Francisco. The startup got off to a brisk start, raised the seed round, and is now ready to enter Series A. There are three possible scenarios: good, moderate, and bad.
In a good scenario, the startup will open several dark stores near universities and add to its drone base. The company has a small but stable income due to its loyal customer base. In addition, one blogger has made it a tradition to order sandwiches on Thursdays and pick them up through the roof of the car in a traffic jam. If the startup raises a Series A round, investors should take advantage of the pro rata right.
In a moderate scenario, the startup will also open a few dark stores, but will miscalculate the location. This leads to a jump in monthly revenue and the unexpected departure of one of the founders. New ideas are needed, so the team is seriously thinking about a pivot. To that end, they are raising a Series A round. What do investors do? That's right, they pass.
The bad scenario repeats the moderate scenario with one difference – the round is announced, but unsuccessful. In other words, none of the investors showed up. In that case, the founders of the startup decide to raise money, but at a lower valuation of the company. For current investors, this is sad news, as their shares take a hit.
Compensation
Affected investors need to be compensated for their losses. There are several ways to do this. We will consider two of the most popular: full ratchet and weighted average.
The full ratchet method means that the startup compensates investors with its own shares. In this case, the shares of the founders may greatly decrease.
In the case of the weighted average method, the old and new prices per share are recalculated. As a result, we get an average value. This method leads to a reduction in the shares of both founders and investors. At least everything is fair.
In conclusion
Pro rata refers to the basics of venture capital investment, so it is not only useful to know about this stuff, but also necessary. Remember that in the future, you will still have to splurge if you want to keep your previous position in the capital of a powerful startup. If that's the case, put some money aside right away and be ready to make a decision. Sure, it's not a poker game, but sometimes a timely pass will save your money better than a ghostly exit over the horizon.