As our seed companies have matured and gone on to raising Series A, without question a key issue that comes up is pro-rata right in the companies next financing round. As Fred Wilson recently covered, these pro-rata rights are a source of much much dissension.
Pro-rata rights are the rights to maintain your ownership after the next round of financing. Let’s say you own 5% of a company after having invested in the seed round— the new investors dilute the existing shares of the existing shareholders— pro-rata rights allow you to participate in this subsequent round of funding to maintain your level of ownership in the company.
An investor’s ability to continue to invest in a company can have a major impact on the return profile of their fund and thus greatly impacts the returns of the LP capital. It is the manager’s job to be an effective steward of that capital. In almost all of our investments, I pre-negotiate the term so that we will have the right to continue to support the company.
With that said, I understand an entrepreneurs point of view when a new investor comes in and offers the company a significant amount of capital and implies they need to meet a certain ownership target to be able to invest. Since there is only so much equity to go around each financing round, this puts the entrepreneur is a tough spot— on the one hand there is an agreement they negotiated with their early supporters, and on the other hand they are being offered the precious jet-fuel they need to keep the company going.
There are two important issues here:
#1: Clear expectations and clear results pre-negotiated at the time of financing.
I have seen some of the savviest entrepreneurs I know pre-negotiate with investors what they want out of the relationship. Recently I saw a founder get a lead investor to commit to a number of customer introductions, and another founder that got all of his investors to commit to blogging about the company.
I think my friend Casey Winter’s point about the spirit of the agreement between and investor and a founder at an early stage is often not held up by the investor. While a founder may promise an investor the right to invest in the follow on round, an investor may also promise particular “value add” that often isn’t delivered. If the exchange between the investor and the company is more clearly defined up front, I think we will see less disagreement about these issues moving forward.
#2: VC Collusion and the ‘Need to Own Baloney’
Typically a new investor coming into a company will have an ownership threshold and they loudly communicate that to an entrepreneur. For Series A funds it is usually 20%.
I have seen founders come back to existing investors, asking them to cut back their ownership, because new investors have an ownership threshold they need to make their fund economics work, and they jam it down the founder’s throats. This is a classic case of the needs of a venture investor clashing with that of the company (and its existing shareholders and agreements with them).
I understand that some VCs need 20% of a company to make their fund economic models work, but this is effectively a problem of their own making and not one that the founder/entrepreneur signed up for. Just because a VC tells founders they need to own 20% of company doesn’t mean it should justify going back on previous agreements.
The typical Series A VCs say they need to own 20% of a company. If founders do have lots of different offers though, they have the ability to negotiate and change the 20% ask.
Therefore, I have often consulted our entrepreneurs to take the 20% threshold number VCs tells them as a beginning point of the negotiation, and focus more on the value they are getting from that investor and how that value relates to the proposed ownership.