What are pro-rata rights?
In the context of private investments, pro-rata rights refer to the privilege granted to existing investors to maintain their proportional ownership in a company when new equity or financing is issued.
When a company decides to raise additional capital by issuing new shares or securing external funding, pro-rata rights ensure that current investors have the opportunity to participate in the new investment round and purchase a proportionate number of new shares relative to their existing ownership percentage.
The pro-rata right is a contractual provision typically included in investment agreements, such as shareholder or subscription agreements. It is intended to protect the interests of early investors by allowing them to avoid dilution of their ownership stake in the company as it raises more capital.
How do they work?
- Informing investors: When the company plans to raise new capital, it must notify existing investors of the opportunity to exercise their pro-rata rights. They should be aware of typically the new investment terms, the number of additional shares available, and a deadline for response.
- Exercising the Right: Existing investors who wish to maintain their ownership percentage can choose to exercise their pro-rata rights by investing additional funds in the company. The amount they invest is calculated based on their current ownership stake, ensuring they can purchase a proportional number of new shares.
Suppose an existing investor chooses not to exercise their pro-rata rights. In that case, their ownership percentage will decrease as a result of the new investment, and their stake in the company will become proportionally smaller.
Are they attractive? For whom?
- For early-stage investors, pro-rata rights can be essential: By exercising their pro-rata rights, investors can avoid dilution, hence maintaining their level of influence and financial interest in the company as it grows, even though new shares are issued to new investors.
- For entrepreneurs and founders, offering pro-rata rights to initial investors can incentivize early support and foster long-term partnerships.
Are they common practice?
Pro-rata rights can vary, depending on the terms negotiated between the company and its investors. Thus, it's crucial for all parties involved to thoroughly review and understand the provisions outlined in the investment agreements.