Posted by Assure ● Sep 3, 2020 12:41:02 PM
Pro Rata Rights: Maintain an Equity Stake Without Dilution
When Assure Co-Founder and CEO Jeremy Neilson managed the renowned $300 million Utah Fund of Funds economic development program, he heard hundreds of pitches from investment managers eager for the cash and imprimatur of an investment from the program in their respective firms. In all of these pitches, not one solitary time did the fund managers use the words “pro rata rights.”
This belies the reality that these rights can exercise immense strategic impact on a fund’s performance. Fund managers talk about how they “follow their winners” by investing more capital. Pro rata rights are what provides an investor or firm with the right to make follow-on investments in their star portfolio companies and to maintain their equity stake without dilution.
One particular venture capital fund made a concerted effort to receive an investment from the Utah Fund of Funds. At the time, the VC fund looked very solid on paper as its managers endeavored to bring the final dollars in to close their second fund. Due diligence revealed that in their first fund, the managers did not have a disproportionate amount of equity in their best portfolio companies; rather their capital was fairly evenly distributed across the entire fund portfolio. Jeremy concluded that either the managers didn’t know how to identify their winners – an unlikely event – or they had failed to receive the right to invest more capital. In other words, they didn’t have pro rata rights. This failure cost the fund investors millions of dollars in additional returns and increased its degree of difficulty in fundraising.
After Assure began to power AngelList and other networks with its structuring and administrative services, Jeremy and the team began to hear the term “pro rata rights” with much greater frequency.
Pro rata rights are the legal entitlement to invest more capital when the company raises additional funds. Usually this is at a higher valuation than in previous rounds. This legal right needs to be negotiated, and it is usually only offered to “major purchasers,” meaning investors with meaningful equity positions.
Pro rata rights are only applicable when you are investing into startup companies – specifically, it is usually only applicable in the early financing rounds of a startup company.
ARE PRO RATA RIGHTS GOOD FOR STARTUPS?
Obviously, devoting more capital into a company that in the future has a strong positive exit will result in high returns for investors. This is not a difficult concept to digest. Having a pro rata right and using that right could result in millions and millions of additional returns. In reality, pro rata rights benefit the investor. Do they benefit the start-up company? They might, but not necessarily. If a start-up company achieves success, then finding new investors is easy and might be preferable to taking more capital from existing investors, because they can bring in new perspectives and expand networks of influence.
Startups are not going to give away pro rata rights to anyone. These rights can be extremely valuable, so startups only offer them to major purchasers. For seed-stage investors, the threshold for pro rata rights might be $250,000. For A round investors, the requirement might be $1 million or it might be $10 million, depending on the valuation and other variables relevant to the negotiations. This very scenario is why many of Assure’s clients tap into our expertise to structure and administer a capital-raising SPV, pooling a number of investors allows the SPV to reach the pro rata rights threshold.
As we circle back to the structuring and administration of pro rata allocations, we should reiterate that pro rata rights are only relevant when a company is raising more capital. Jumping ahead to the structuring step, let’s assume you have acquired the pro rata right and have decided to exercise this right. What do you do next?
A FUND MANAGER CAN TAKE ONE OF THREE MAIN APPROACHES TO PRO RATA RIGHTS:
Fund managers can accept the rights and invest from the same investment vehicle from which they made the initial investment into the company.
A. Fund managers of traditional venture funds can issue a capital call for the needed capital, and invest this additional capital into the startup company.
B. Micro or nano VC fund managers might do a capital call, but more likely will need to use approach 2 or 3 below.
C. Finally, if a capital-raising SPV was used as the investment vehicle, fund managers would raise new funds from existing investors to deploy the capital from the current SPV vehicle.
Accept the rights and set up a new SPV vehicle. Investors from the original SPV and/or new investors could provide the capital.
Accept the rights and give them to a third party. If this is done, a new SPV can be set up in the interest of sharing in the economic benefits.
A FEW EXAMPLES OF APPROACHES TO PRO RATA RIGHTS:
Micro or Nano VC fund—Let’s say a micro fund raises $10 million in capital. The managers invest this $10 million into 50 seed-stage startup companies. That is on average $200,000 per portfolio company. After 12-to-24 months, all $10 million has been invested. Then some of the 50 companies start to progress and show promise. If the micro VC fund negotiated pro rata rights, they would need to use approach two or three to raise additional fund for its pro rata allocation rights.
Some investors that network with small funds, such as the micro and nano- players, will want to be a part of approach three. When these smaller funds cannot raise enough funds alone or don’t have enough in reserve to capture all of their pro rata allocation, they call for investors. Carry is usually shared between the parties, and the new combined group raises capital for these unused allocations.
NOW LET'S WALK THROUGH THE BENEFITS AND NEGATIVES OF EACH APPROACH
The First Approach : Accept the rights and invest from the same initial investment vehicle.
The benefits of this approach include the fact that using the existing structure keeps costs low and that you don’t need an additional entity to manage the investment. The negatives for this approach are that adding new investors that weren’t original investors requires specialized language in your SPV fund documents. Additionally, preparing tax returns and managing the cap table is more complex and requires more administrative effort than other approaches.
Second Approach: Accept the rights and set up a new Special Purpose Vehicle.
Both the benefits and the negatives are the inverse of the first approach. Benefits include a clean cap table, simple administration and the ability to add new investors that didn’t originally participate in the deal. The main negative is that costs are higher because it requires a full SPV service.
Third Approach: Accept the rights and give them to a third party.
The primary benefit of this approach is that you actually get direct value for this pro rata right, which is an asset for the fund. The value usually comes in the form of carry in the new investment vehicle. You also can be seen in a favorable light with the startup company, showing them that you can provide capital when the company is successful. Impressing CEOs is relevant when you want access to a new startup, and you are allowed to invest because you have the reputation of bringing capital to the company through multiple financing rounds. The conspicuous negative is that you are not in control of this pro rata right – you had to use a third party to fill the allocation.
Let me provide some examples of approach three in the market:
Some managers have a pro rata strategy in which they raise a fund to make the initial investments. They then raise a second fund to invest in the pro rata allocations of the first fund. These second funds are sometimes called “Opportunity Funds.” Some managers don’t raise two funds, but rather have a single fund that makes the initial investments and then uses capital-raising SPVs to fill the pro rata allocation rights.
SUMMARY OF PRO RATA RIGHTS
Let’s recap the structuring of pro rata rights: You may use an existing structure – typically the original investment vehicle that made the first investment – into the start-up company. Or you will structure a new SPV or other funding vehicle.
Approach One: Re-open the SPV. Open a bank account and onboard investors. If they are new investors, get fund docs signed, KYC/AML checks, wire funds. Complete the signing of the purchase agreement, issue capital account statements, cap table adjustments, taxable event requirements (i.e. tax returns), post-close activity requirements, distributions and wind-down.
Approach Two: This is a new SPV so everything needs to be done: New entity, EIN, bank account, fund docs, onboarding, KYC/AML, wire funds to company. Complete the signing of the purchase agreement, issue capital account statements, cap table creation, tax returns, post-close activity requirements, distributions and wind-down.
Approach Three: This is a new SPV (led by the acquiring group). Mirror every step enumerated in Approach Two. Regardless of the structuring approach you take, the steps and amount of work is nearly identical. When it comes to the administration of a structured investment vehicle, the admin will be the same as that of an SPV or VC fund. For a more in-depth explanation, you can listen to our Anatomy of an SPV and the Anatomy of a VC Fund Assure Podcast episodes by co-CEO Jeremy Neilson.