Pro-Rata Rights: Understanding Investor Ownership in Funding Rounds

Pro-rata right is a legal term that describes the right, but not the obligation, that can be given to an investor to maintain their initial level of percentage ownershipStockholders EquityStockholders Equity (also known as Shareholders Equity) is an account on a company's balance sheet that consists of share capital plus in a company during subsequent rounds of financing.

In other words, if an investor with a pro-rata right initially acquired a 10% equity stake in a company, then he or she is given the option to invest more in the next rounds of the company’s financing to maintain a 10% stake. The term pro-rata right is commonly used in venture capital financingVenture CapitalVenture capital is a form of financing that provides funds to early stage, emerging companies with high growth potential, in exchange for equity or an ownership stake. Venture capitalists take the risk of investing in startup companies, with the hope that they will earn significant returns when the companies become a success..

How Do Pro-Rata Rights Work?

The idea of a pro-rata right is essentially related to the concept of dilution. Each new round of equity financing implies the issuance of new shares. When new shares are issued, the percentage of the equity stake of current shareholders (foundersFounders StockFounders stock refers to the equity that is given to the early founders of an organization. This type of stock differs in a few important ways from common stock sold in the secondary market. Key differences are (1) that founders stock can only be issued at face value, and (2) it comes with a vesting schedule., investors) is diluted. In other words, the current shareholders lose part of their voting power as calculated on a percentage basis.

In order to prevent such a scenario, the investors can ask a company to include a provision that grants them pro-rata rights. The investor with the pro-rata right is then able to maintain the percentage of their equity stake and voting power even with the issuance of new shares.

Note that the pro-rata right is not an obligation, and it can be exercised at the discretion of its holder. Some investors with pro-rata rights may opt not to exercise their option to invest in the next rounds of financing. The reasons for abandoning the rights include poor performance or development of a company, as well as extremely large additional investments required to maintain the initial ownership percentage.

In addition, in some cases, investors do not receive pro-rata rights. Some companies opt to grant such rights to valuable investors who have made a significant impact on the business.

Pro-rata rights are generally granted to, or asked for by, investors who invest in early rounds of financingSeries A FinancingSeries A financing (also known as series A round or series A funding) is one of the stages in the capital-raising process by a startup. Essentially, the series A round is the second stage of startup financing and the first stage of venture capital financing.. The investors are often not willing to exercise their rights in the later financing stages due to the high investment amount required.

Additional Resources

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To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

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• Rights IssueRights IssueA rights issue is an offering of rights to the existing shareholders of a company that gives them an opportunity to buy additional shares directly from the company at a discounted price