Lee Edwards, the partner at Root VC, has a saying at his firm that “pro-rata rights are earned, not given.” That may be a bit of a stretch since pro rata refers to a term that VCs put in their term sheets that gives them the right to buy more shares in a portfolio company during consequent funding rounds to maintain an ownership percentage and avoid dilution.
The Expense of Pro Rata Rights
Still, while these rights are not precisely “earned,” they can be expensive. One of the latest trends in VC investing is funds dedicated to helping seed VCs exercise their pro rata rights.
Challenges in Exercising Pro Rata Rights
The problem is that the new lead investor will usually get its preferred allocation in later rounds. Meanwhile, other new investors try to get what they can, while existing investors have to pay whatever the lead has agreed to pay per share if they want to exercise their pro rata rights.
And, often, the new investors would prefer to squeeze pro rata investors out of the round altogether and take more for themselves. Meanwhile, founders want to cap the total chunk of their company they will sell in the round.
Founder Support for Early Investors
“It’s pretty common that a downstream investor will want to take as much of the round as they want and will sometimes tell the founder they need an allocation that’s so large, it wouldn’t leave room for pro rata rights — essentially telling the founder to ask earlier investors if they would willingly waive their pro rata rights,” Edwards told TOPCLAPS.
The Decision Not to Exercise Pro Rata Rights
Sometimes, venture capitalists don’t choose to exercise their pro rata rights. While they obviously might pass on buying more shares in a struggling startup, they are often forced to pass up buying more of their winners because they can’t afford them.
Between 2020 and 2022—during the VC investing frenzy years, for example—Edwards saw many early-stage funds decline to exercise pro rata on later-stage rounds due to what he called “eye-popping valuations.”
The Role of Investment Companies in Pro Rata Funds
Indeed, new investors in later rounds often run more significant funds than seed investors and can pay more per share, making it challenging for early-stage investors and smaller funds to keep participating in later rounds.
This is where investment companies like Alpha Partners, SignalRank, and SaaS Ventures come in. All three deploy capital at the Series B level and later rounds to support seed-stage and Series A VCs who want to exercise their pro rata rights.
SaaS Ventures’ Approach
When, for example, Sequoia invests in a Series A, other existing investors can participate,” SaaS Ventures partner Jesse Bloom told TOPCLAPS. My job is to hear from my network that it is happening to find Series A investors and offer to stake them in their pro rata. I give them money to invest in their pro rata and get 10% of the carried interest.”
Most, if not all, of the names on the list of top-tier VC firms Bloom monitors for later-stage deals are those you recognize, from Andreessen Horowitz to Insight Partners to Valor Equity Partners.
Quick Decision-Making in Investments
He can also make quick decisions because if a top-tier VC fund leads a deal, he doesn’t have to do as much diligence, saying, “That’s the only way I can get in—I’m betting on the unfair advantage of the top guys.”
Bloom said that’s another reason he only invests in deals led by a list of the top 25 VC funds on its website. “We believe access beats diligence in the long run in later-stage venture capital and will do whatever it takes to gain access to deals led by our top funds, even if it means we don’t know as much about the company,” he said.
SaaS Ventures’ New Fund
Bloom previously worked at Alpha Partners before SaaS Ventures leaders Collin Gutman, Brian Gaister, and Seth Shuldiner hired him to raise a fund for them that would compete with Alpha.
He has now closed a new fund for SaaS Ventures with $24 million in capital commitments to invest in those pro rata opportunities. The new fund limited partnership is anchored by Pennington Partners, which manages multiple family offices.
Recent Deals by SaaS Ventures
Bloom has made five deals already, including Apollo.io’s Series D and MaintainX’s Series C, both led by Bain Capital Ventures; Cover Genius’s Series E, led by Spark Capital; and Elisity’s Series B round, led by Insight Partners.
The Pro Rata Boom
Bloom’s not alone in finding success for pro-rata-targeted funds. According to an SEC filing, Keith Teare’s SignalRank is going after a $33 million fund that it started raising in January. According to Steve Brotman, managing partner at Alpha Partners, alpha is also raising a new fund to target pro rata. The firm secured over $125 million in capital commitments, and he expects to close at the end of July with over $150 million.
Importance of Pro Rata for Early Investors
Since many early investors on a company’s cap table write $1 million to $3 million checks, pro rata is traditionally the only way they can get into these more significant deals, Bloom said. Similarly, for founders, this type of deal supports their existing investors.
“We are essentially the LPs of their existing investors so they can have pro-rata anti-dilution rights,” he said. “At some point, the founders will cut out existing investors, so I give them access to cheap and quick capital.”
Changing Trends in Pro Rata Deals
As Root VC’s Edwards mentioned, two years ago, investors weren’t rushing to make pro rata deals. Today that seems to be a different story. The pro rata game is heating up, according to Bloom and Brotman, who say much of this comes from fewer deals being done at later stages, so getting access to those big-ticket deals is more challenging.
Increasing Challenge in Funding Pro Rata Rights
Investors said this leaves an abnormally high number of VCs unable to fund their pro-rata rights. Brotman says that as much as 95% of the time, investors don’t do their pro rata.
The Blackjack Analogy
He likened it to playing the card game Blackjack, and if you have a particular hand, you can double down on your bet, depending on what the dealer is showing. “If you don’t double down when you can, the house wins. The same is true in venture capital, but no one’s bothered to talk about it,” he told TOPCLAPS.
Importance of Exercising Pro Rata Rights
Well-known angel investor Jason Calacanis, founder and CEO of Inside.com and Launch, sat down with Brotman in May for his podcast, “Driving Alpha.” Calacanis told Brotman that if he had utilized his pro rata follow-on rights in his first fund, he could have tripled the returns, which already achieved a 5x return. So why didn’t he?
“Well, back in that day, you were trying to use your 100 swings at bat, or in the case of this $10 million, 109 swings, to hit one outlier based on the Power Law,” Calacanis said. In this case, the “Power Law” is where one single investment yields returns larger than all other investments combined.
Risk and Duration in Venture Capital
Risk and duration are affected among institutions and family offices, with duration “really being the killer,” Brotman said. He said many institutions don’t have 10 to 15 years to prove their worth—more like three to six years.
Long-term Benefits of Pro Rata Rights
Venture capitalists need to double down on their winners and speak with their founders about why they must do so. Also, if they can do their pro rata rights, they can often stick around on the board, which is essential for early VCs, Brotman said.
“A big component of being a venture capitalist is being able to ride your unicorns,” he said. “Even if they’re not on the board, the fact that they’re investing, the CEO still will spend more time with them and answer their calls.”
