Pro rata rights and how they can affect seed funds are important for both seed-stage investors and founders. Having pro rata rights allows an investor to continue to put money into the company in future rounds, and by doing so the investor maintains their initial ownership percentage in the business.
Naturally, everyone wants to put more money into winning companies, the ones that are doing really well and are set to generate big returns. Seed and pre-seed investors think in exactly the same way.
Because you know (or at least have a good feeling) that the company you are investing in is one of your winners, you want to keep on investing capital into that company for as long as it looks like it is still winning.
Balancing Gains and Losses in Seed Investing
Investing in winning companies is really important for seed investors, because they have a much higher loss rate. Very early-stage startups fail more often than larger, more established later-stage startups. Seed funds trade a lot of uncertainty in the early days of a business for lower valuations. They know that they need to be able to plow additional capital into their winners, since they are guaranteed to have so many losers.
If you look at the loss rate between a seed fund and a later-stage fund, the seed fund’s rate will be monumental in comparison. Later stage venture investors invest in relatively safer companies that are more mature. These companies may be earning (or close to earning) revenue. They know where they are going on product – they are further along in development.
So seed investors take much higher risks for a greater profit in the long run. The companies won’t be as advanced but they will hopefully turn into winners.
How Pro Rata Affects Seed Investors
This brings us back to why having pro rata rights is so important for seed investors. Seed funds have to put a lot of capital in the early rounds in order to reap any rewards when the company is successful. If they are blocked from investing more money in the future rounds that creates a really big problem. Without pro rata rights they have really only got “one shot on goal,” and they will suffer a lot of dilution as the company continues to raise more capital along the way.
The seed fund’s ownership percentage in a company could be reduced from 10-20% all the way down to a couple of percentage points, and this could be the difference between life and death for a seed fund. Due to the high loss rate, a seed fund will only have in the realm of one to three companies that provide enough return to support the whole fund.
If seed fund investors are blocked and cannot continue to put more money into those companies, the fund may be looking at a mediocre outcome. This has the potential to lead to some serious consequences. Without pro rata rights, a seed fund might not post solid returns, be able to raise more money, or create other funds in the future.
So seed investors take pro rata rights very seriously, and you will see them fight tooth and nail when a later-stage investor tries to cut them out of the pro rata. They know they need pro rata to survive.
Pro Rata Rights Make a Big Difference
If you are a founder and you are taking money from seed stage investors, remember it’s a very complex relationship. Providing pro rata rights could mean that your original investors will stay with you for the long haul. And you should keep in mind that your seed investors took the first chance on you and they gave you the money to build your company. So when you start discussing pro rata rights, both you and your seed investors need to agree. Both of you want to do what’s best for your startup, so you should be open and communicate with your seed investors.
If you have any questions on seed funds, startup investing, startup accounting, taxes or venture capital, please contact us. You can also follow our YouTube channel and our blog for information about accounting, finance, HR, and taxes for startups!
