June 17th, 2007
I read, like, and regularly disagree with a great blog called Ask the VC . They recently answered a question about supra pro rata rights—here are our thoughts on the topic.
Q: Can you explain what supra pro-rata is? It seems to be showing up in some VC term sheets now. What’s the impact on the entrepreneur? How hard should one try to negotiate it out? If a VC insists on this term, should the entrepreneur walk away?
A: First, read Ask the VC’s response—we agree with them. Here are our additional thoughts.
An investor with supra pro rata rights wants the option of increasing his percent ownership in the next round. He probably told you “We like this company so much we might want to buy more of it!”
Investors who want to increase their ownership drive down your valuation.
Investors who want to increase their percent ownership try to drive down the next round’s valuation. Whether or not they have supra pro rata rights.
They are at odds with the founders and management who are trying to increase the next round’s valuation. These investors can exercise their protective provisions to veto everything but the lowest valuation offer. Or they can signal the “correct” valuation to new investors:
If the current investors want to increase their percent ownership, the valuation is too low. If they don’t want to increase their percent ownership, the valuation is too high. This makes it harder to get a high valuation since the new investors often believe the current investors have a better sense for the right valuation.
You want investors who maintain their percent ownership.
You prefer investors who make it a policy of maintaining their percent ownership in the next round. This incents them to increase the next round’s valuation.
These investors don’t try to increase their percent ownership because they know it puts them at odds with the founders and management. They know it incents them to use their protective provisions to veto good offers. They know it forces them to signal their sense of the correct valuation.
Your response to supra pro-rata rights is:
“Everybody around the table should be working together to get a high valuation in the next round. Investors and management shouldn’t be at odds with each other in the next financing—let’s create alignment, not mis-alignment.”
Investors who try to decrease their percent ownership in the next round are also bad news. They signal that the valuation is too high. (Angels and seed stage funds are an exception. They’re not necessarily expected to maintain their percent ownership since they may not have a lot of capital.)
What are your experiences with supra pro rata rights?
Use the comments to share your experiences and questions about supra pro rata rights—we’ll discuss the most interesting ones in a future article.