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 ownership 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 financing.
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 (founders, 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 financing. The investors are often not willing to exercise their rights in the later financing stages due to the high investment amount required.