For a long time, I was a strong believer in investor pro ratas. As a founder, I understood the trade and was comfortable with it. As a partner at YC, I thought it made enough sense that I helped design an entire programmatic pro rata system that covered every investment YC made. I reasoned that the usual mechanic of a pro rata let an investor continue to buy ownership as a reward for an early bet and continued help, and that founders could always use extra money.
I was wrong. Pro rata is actually a bad term for founders dressed up as a “business model” or “support” feature. I learned this the hard way, through many uncomfortable conversations with founders where I insisted on getting pro rata in tight rounds where the founder wanted to bring in new investors or limit dilution. I learned this through rough conversations with founders who expected a pro rata investment during a difficult fundraise and didn’t get it. I saw the warping influence of pro ratas in the way that founders communicated with investors around fundraising and needs.
This took a long time for me to see because, well, I had conflicted incentives. I spent most of the last ten years as an investor, and investors want pro ratas in term sheets because it is, essentially, an option on a future financing. In and of itself, this is ok. The problem is that the option is:
Free
One sided
Unrelated to value
Ignored constantly
The option is free because an investor does not have to pay more to get a pro rata right - it is generally called “standard” and left at that.[1] It is one sided because I’ve never seen a situation where an investor was forced to do a pro rata against her will, whereas I have seen, and have been a part of essentially forcing founders to take pro ratas that they did not want.[2] Pro ratas are unrelated to value because they do not correspond to the amount of work/value/help that an investor actually provides over time beyond an initial financing. There are investors who are incredibly helpful to founders that earn the trust of founders who are then invited to invest more - or not. There are investors who do a bit here and there and then march up to the table and demand their ownership when a financing rolls around. There are investors who request pro rata, and then, at financing, ask for what they can get. There are founders who say to particularly helpful investors: “Hey - your team is amazing. Do you want to buy ownership in this round?” On top of all this, the term is ignored so often in so many ways that it seems a bit like a strange legal joke.
Maybe the most ridiculous piece of the whole thing is I have yet to meet an investor who has said “We looked at your cap table, we see you have promised pro ratas. Of course we will honor each of those perfectly and adjust our terms to account for your early investors.” This simply doesn’t happen. Each new investor does their darndest to get as much ownership as possible, previous contractual terms be damned.[3][4]
I spent a long time trying to build continued value for founders in order to make the pro rata more of an even exchange. But in the past, I never actually made that trade clear and two sided. The way this should work is as follows:
Investor wins deal to invest money at time A for ownership B.
Investor and founder hit it off. Investor works butt off to help company as requested by founder.
Company raises a new round. Investor is helpful in this.
Founder asks investor - or investor asks founder - to buy more ownership.
Negotiate, decide, move on.[5]
Or, maybe this better:
Investor wants to invest, makes offer. Investor wants pro rata.
Founder says “cool, I like you, if you want pro rata, you’re going to have to sweeten the offer by x.”
Investor agrees to change in price/dilution some other trade and gets pro rata
Pro rata is now a mutually agreed, purchased, more weighty term
Sure, founder could still try to reduce pro rata later since any contract can, technically be broken. However, this would be a valid place for an investor to go to war.[6]
This would align founders and investors in a far better way than a contract. Contracts aren’t worth spit.[7] Relationships are what counts. Working with people who value good work matters. Pro ratas ignore those nuances and are out of step with how startups and venture capital work. There's a way for pro rata to become a good term, but the term will have to evolve to get there.
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[1] Crazy! This is valuable term! Investors should have to pay more to get it.
[2] There’s a lot of ways to make this argument. The arguments aren’t morally wrong, they’re in fact the right argument in situations where a founder has signed a contract to do something. But here’s the thing - the contract shouldn’t exist in the first place.
[3] Allowances here are sometimes made for “good friends.” Incidentally, “good friend” is my favorite term in venture. It almost never means actual friend. Real friends rarely talk about how close they are to third party business associates.
[4] When founders do say “hey, we have pro ratas we want to honor,” the response is generally “ok, for sure, go ahead, but the post stays the same.” This is another way of saying “Dear Founder - you take the dilution!” One could argue that this is a fair response, that the founder made the commitment and has to honor it, but it would be nice to see some give and take in the conversation.
[5] This is certainly complicated. This model would imply that there are gradations of help provided by investors to founders, and that a founder who declines more ownership would receive less help over time. Of course, this is true. Some founders in a portfolio do, in fact, get more help than others. I also get that this also applies a fiercely mercantile lens to any interaction between investor and founder. But I’ll also argue that that is, in fact, a primarily mercantile/capitalist relationship. The relationship does sometime morph into an actual friendship at which point there are wildly different and more complicated rules because emotions.
[6] Or court, since that’s how business usually works.
[7] While I do think that contracts have value, I’ve seen enough lawsuits and renegotiations to know that the contract isn’t what keeps people from doing what they promise to do.