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Author: Seth Levine, Mobius Venture Capital
Brad’s given me permission to co-opt his blog for the day. I work for Brad (and had a great time recently up in Alaska “working”) which gives me an unusual vantage point from which to consider some of his posts on the world of VC. After reading several of these posts (and of course living in this world with him) I came up with the great idea of suggesting to Brad that he write a post about deal splits and the notion of what investing “pro-rata” actually means. Brad had an even better idea which was to have me write the post (which, of course, made my original idea seem not quite so brilliant).
The question of what “pro-rata” means in the context of a deal seems, on its surface, pretty straight forward. Simply put this question asks how much each investor intends to invest in a financing round. However, as is often the case when you get two VCs in a room and ask them to decide on something, actually agreeing on what this is becomes another matter all together. One investor’s view of the meaning of “playing their pro-rata” is often different from that of another. Unfortunately, in many cases this isn’t discovered until late in a financing process leaving an entrepreneur scrambling to reset expectations and either make up a gap in a capital raise or placate an investor who believed they would get the chance to invest more in a round. Ask most VCs and they’ll tell you everyone knows what pro-rata means (try this – its can be amusing); end up with confusion around this in the 11th hour of a financing and you’ll realize that this is definitely not the case.
The best way to illustrate the complexity of this concept is to take a look at a couple of examples. Take the case of a Series A round for ProRata Corp. Assume the post money on the deal is $8m and each investor, having invested $2m each, ends up owning 25% of the business. Fast forward to the Series B financing and consider two scenarios. In the first scenario there is no outside investor and the company raises $6m. Logically, each investor would contribute $3m to the financing, as each was responsible for 50% of the prior financing round. Note that this would leave them each owning just under 36% of the business post financing – meaning that by some definitions they actually played above their pro-rata amount because they have each increased their ownership in the business. Now consider the same case where a new investor is brought into the mix in the Series B. Assuming this investor takes $2m of the $6m round, is the pro-rata for the remaining investors $2m (half of the remaining $4m)? It could also be $1.5m (which, in the $6m round would allow the investor to retain their 25% ownership). Of course in that case there would be a shortfall. I know this sounds crazy, but this exact situation happened to us about a month ago (and plenty of times prior to that). Each of Mobius and the other existing investor was talking about contributing our pro-rata amount to the financing – our believing that this meant that the two existing investors would split the remainder of the round based on their relative ownership percentage; the other investor believing that they would retain their ownership percentage in the business. In that case Mobius made up the difference – we were strongly supportive of the business and happy to increase our ownership – however if we had not been in a position to do so, the company would have been left with a gap in their financing plan.
This example was actually pretty straightforward. Things start to get much more complicated for a company that has raised multiple rounds of financing, has shareholders who own several classes of stock (common, junior preferred, senior preferred (perhaps with a change in their conversion ratio due to anti-dilution), warrants, etc.). In those cases, what constitutes pro-rata? Even in our relatively simple example where all of the new money in a round is coming from existing investors this a complicated question. Do the shareholders split the round based on their total as-converted common ownership? Do they only count their senior preferred in the calculation? Do they include their entire preferred ownership position? The different methods of calculating pro-rata in this case can lead to vastly different views on investment amounts. This is important by itself, but becomes even more so in the case where a company is doing a down round financing where failure to participate pro-rata will lead to losing preference rights or some other penalty. Interestingly within venture funds this is also an issue, as funds that have made cross fund investments (that is investments in the same company from more than one of their funds over time) also need to determine how to split an investment between funds.
There is no neat conclusion here. The concept of pro-rata participation is something that sounds in theory like it should be pretty straightforward, but in practice rarely is. Out of this confusion, the important point for entrepreneurs and investors alike is to make sure they have a discussion about participation amounts early in the investment process. Discrepancies in expectations can always be dealt with more constructively if there is time to spare, rather than at the last minute.