What is Pro-Rata Right?
Pro-rata right is a legal term that describes the right, but not the obligation, that can be given to an investor to maintain the initial level of percentage ownership in a company during subsequent rounds of financing.
In other words, if an investor with a pro-rata right initially acquired 10% equity stake in a company, he or she is given the option to invest more in the next rounds of the company’s financing to maintain their 10% stake. The term pro-rata right is commonly used in venture capital financing.
How Do Pro-Rata Rights Work?
The idea of 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 equity stake of current shareholders (founders, investors) dilutes. In other words, the current shareholders lose part of their voting power.
In order to prevent such a scenario, the investors can ask a company to include a provision that grants them pro-rata rights. In this case, the investor with the pro-rata right will be able to maintain the percentage of its 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 the pro-rata rights can 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 can 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 by investors who invest in early rounds of financing. The investors are usually not willing to exercise their rights in the later financing stages due to the high investment amount required.
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