VC Generally Retain Pro-Rata Rights

by Mark Peter Davis

In my posts, Investors Tranche Fundraising To Reduce Risk and How Tranching An Investment Can Affect Investor Ownership, I describe hypothetical scenarios where the VC has an option of leading two consecutive investment rounds.  In practice this isn't often the case.  Most VC term sheets give them pro-rata investment rights, not the right of first refusal on the entire investment in future rounds. 

In many cases VCs seek outside (new) investors to lead subsequent rounds of financing of a company.  While the economic incentives for having an outsider lead the round vary by fund size, outsiders are often sought to lead new financing rounds because they can provide additional contacts for management and external validation of the company's valuation. 

The valuation provided by an inside (existing) investor is not considered to be as solid of a market number as insiders have an incentive to both minimize and maximize the price of the round, creating a dynamic that leads to less reliable market valuations.  At a higher valuation, the insider protects their existing investment from dilution and at a lower valuation they are able to buy shares at a lower price.  They have conflicting incentives.

The external valuation is important for investor bookkeeping, setting prices for options and warrants,  and for negotiating exit valuations.

As a result, most VC term sheets give them only the right to make their pro-rata investment, not the right to lead subsequent rounds. 

So, what is pro-rata?  It's best to explain with an example.

If the company wants to raise an additional $10 million of capital, they may find a lead investor who is only willing to provide $5 million of the round.  The remaining $5 million dollars may be made available to the insiders, or existing investors.  In sum, the $10 million would be split 50/50 - $5 million from the outsider (new) investor and $5 million from the insider (existing) investors. 

Each of the existing insiders would have the option to invest up to their pro-rata percentage of the inside portion.  The pro-rata percentage is defined as the percentage of the total capital already invested in the company that they provided.  Let's assume a VC had invested 20% of the total capital taken in by the company prior to this new round.  This VC would then have the option to invest up to 20% of the $5 million inside round - or $1 million.

There are some nuances to this.  Not all investors are granted pro-rata rights and investors usually have the option to invest more if other insiders elect not to make their pro-rata investment.

In sum, VCs don't usually have a "call option" on the next round in a typical venture round (Series A, Series B or beyond).