Meaning of Pro-Rata Participation Rights
Pro-rata participation rights, also known as pro-rata investing rights, or preemptive rights, grant existing shareholders or investors in convertible instruments such as SAFE, the right to participate in subsequent fundraising rounds. The right allows them to maintain, and sometimes to increase, their percentage ownership in the entity. The right is triggered when a company raises funds in further priced or non-priced financings. Should existing investors choose not to exercise this right or elect to exercise their right in part, the new investors in such financing will dilute their ownership percentage in the company.
For instance, if the company has granted investors pro-rata participation right (preemptive), each of the investors entitled to this right will be entitled to participate in future financing, and to purchase a number of shares, or it’s pro rata share in any convertible financing (such as SAFE), allowing such investor to maintain its holdings. Sometimes, the right will also include an over-allotment right, also known as “super pro-rata” or “super preemptive right,” which, in simple words, allows each shareholder or investor to purchase more than what it actually needs to maintain its pro rata, by purchasing unallocated portions which the other right-holders failed to subscribe for.
This right helps attract potential investors because it helps them keep their percentage ownership unchanged and maintain their voting power. These rights only provide an option to investors to purchase shares or convertible securities in future financing rounds and do not create any obligation on their part.
What should you pay attention to?
Pro-rata rights serve different purposes to investors and entrepreneurs. The early-stage startup offers these rights to hold investors for the long term by providing them a tool to maintain their ownership in the company. While it might sound beneficial for both the parties in the short-run, it could create potential problems for the startup in the long run. Thus, the startup should pay attention to the following points before granting pro-rata rights:
- Any company is not under a compulsion to provide pro-rata rights. However, certain laws provide this right to investors by default. Also, once these rights are granted, they are legally binding and the company cannot deny these rights.
- These rights are generally offered to major investors. Major Investor means an investor that holds a certain predefined percentage of shares in the company or a fixed number of shares (depending on the jurisdiction, US companies tend to adopt the ‘fixed number of shares model’, while companies in other jurisdictions favor the percentage threshold).
- As already discussed, major investors must exercise these rights in subsequent financing rounds to prevent dilution of their ownership. But suppose any investor chooses not to purchase its full pro-rata shares in the subsequent financing rounds. In that case, to the extent the company has granted an overallotment right, the remaining major investors shall be entitled to purchase the remaining pro-rata shares. As allocation becomes tight in successful companies, an overallotment right could limit the startup from adding new investors to their cap-table. These new investors may not be able to subscribe for portions of equity the non-participating major investors have decided not to subscribe to.
- Also, the startup must be cautious whether it is beneficial for the company to keep certain investors as core members with substantial shareholding in the long run. Thus these rights must be given to serious investors with experience and significant money.
- Although not very common, another mechanism can be introduced when discussing participation right limitation – a “Pay to Play” provision, which disclaims the right from those investors who fail to support the financing needs of the company constantly. . As a result of this provision, if the investors fail to purchase their pro-rata share of securities, they lose their participation rights.
- The pro-rata rights can also hamper the ownership of the founders in the company. The large investors would maintain their significant ownership, and collectively they can take control and have a major shareholding.
As already discussed, the pro-rata rights are a beneficial tool to attract investors, but it is advisable for the startup founders to be aware of the above-mentioned points, and also take into consideration the consequences of the same. The significant investors who have these rights can always exercise these rights which might create hurdles in securing new financing for the company.
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