Pro-rata rights and follow-on investing

What is a pro-rata right?

A pro-rata right is a contract term that lets an existing shareholder take a share of any new funding round, big enough to hold their ownership percentage steady. 'Pro rata' is Latin for 'in proportion'. If an investor owns 10 per cent of a company, the right lets them buy 10 per cent of the new shares being sold.

Without it, every new round shrinks the investor's percentage. Every round brings new shares, so the same investor owns a smaller slice each time. The right gives the investor the choice to keep up, but not the duty. They can use it fully, partly, or not at all, and the company has to offer them the chance before selling that part of the round to others.

How does the maths work?

Say an investor owns 8 per cent of a startup. The company raises ₹50 crore by selling new shares, and the new shares will be 20 per cent of the company after the round. Without any action, the investor's 8 per cent falls to 6.4 per cent, because 80 per cent of the old company remains. To stay at 8 per cent, the investor must buy shares worth 8 per cent of the whole company after the round.

In practice it is simpler to say the investor can invest 8 per cent of the round, which is ₹4 crore of ₹50 crore, to hold their percentage. Many agreements define the right just so: the investor's percentage multiplied by the size of the new round. The exact wording matters, because some agreements count fully diluted shares and others only issued shares.

Why do early investors want pro-rata rights?

Venture returns come from a small number of companies that grow very large. An early investor does not know in advance which one it will be. The pro-rata right lets them wait and see: invest a small amount early, then put in more money into the companies that show progress, at the new higher price.

This is called follow-on investing. Funds often reserve part of their money for follow-ons from the start. A seed fund may keep a large share of its capital for later rounds in its best companies. The right to do so is not automatic. It has to be agreed, and in the small cheques of a pre-seed round it is sometimes left out unless the investor writes a large enough cheque.

What is the difference between pro-rata and pre-emptive rights?

The two terms are often confused. A pro-rata right is a contractual term that lets an investor buy part of a future round. A pre-emptive right, also called a right of first offer, is a broader idea: before the company sells new shares to anyone, it must first offer them to existing shareholders in proportion to their holdings.

In practice the shareholders' agreement may combine them in one clause. What matters is the detail: who is covered, how long they have to say yes (often fifteen to thirty days), and what the company may do with shares nobody takes up. Founders should make sure the response window is short, so a round is not held up waiting for an answer.

What do founders think of pro-rata rights?

Founders have mixed views. On the positive side, an existing investor who knows the company can commit money quickly, and a follow-on from insiders signals confidence to new investors. On the negative side, pro-rata rights take part of a round that the founder might give to a new lead investor. A new investor often wants a certain ownership percentage, and a crowded round with many pro-rata claims leaves less for them.

Founders can manage this by being clear early. They can limit the right to investors above a certain cheque size, or ask for a 'major investor' threshold. They can also ask that unused pro-rata is not carried forward, so rights lapse if not used in a round. The aim is a round where everyone who adds value has a place, without blocking the lead.

What are super pro-rata rights?

A super pro-rata right is a right to buy more than your current share of the next round, for example to take 150 per cent of your ownership percentage and so increase your stake. It is unusual and tends to appear when an investor has strong bargaining power or has taken a risk early.

Founders should be careful here. Super pro-rata can crowd out new investors and signal that existing investors, not the market, are setting the price. A better answer is often a limited right with a clear cap on the share of any round.

How do pro-rata rights work in India?

In India the right sits in the shareholders' agreement, and the company's articles of association should reflect it so that it binds the company. When the company issues shares, it must also follow the Companies Act, 2013, which has its own rules on offers to existing shareholders (a rights issue) for some issues. Private placements to selected investors are the usual route for venture rounds, and pro-rata terms operate alongside that.

Where an investor outside India is involved, FEMA pricing rules apply to the price at which shares are issued or sold, and reporting to the RBI follows. This is a point for a lawyer. Investors in a Category I or II alternative investment fund (AIF) also face limits on how much they can put in one company, which affects how large a follow-on they can make.

How do funds decide whether to use their right?

A fund looks at how the company has done since the last round, the new price compared with the old one, and how much money is left in the fund. Funds have a fixed pool of capital and a limited time to invest it. A fund that spends its reserve on a middling company has less for the best ones.

Some investors also use pro-rata rights to gain information. Holding the right keeps them in the conversation about future rounds. Others sell the right, or pass it to a co-investor or a related fund, if the agreement allows it. A few angel groups pool their members' pro-rata through a special purpose vehicle, so many small investors can use a single combined right.

The right itself is free, but using it takes real money and is the reason many funds hold back a reserve. A fund that owns 5 per cent in each of twenty companies may need many crores each year only to maintain its position. This is why some investors choose to take pro-rata only in the few companies that clearly work.

For angels the decision is harder, since a single person has limited funds. Some angels join syndicates, where a lead investor negotiates the right on behalf of the group and the members decide each time whether to follow.

What should you check before you sign?

Check who holds the right, how it is calculated, and what happens if it is not used. Check whether it applies to all future rounds or only the next one. Check the exceptions: option grants, conversion of existing instruments and strategic investments are often left out. Check whether the right ends at an IPO, which it normally does.

These terms are negotiated like the rest of the deal. This guide is general information, not legal advice. Have a lawyer or chartered accountant review the agreement before you sign it.

Read next

• Dilution: why founders own less after every round
• What is a cap table?
• The term sheet, clause by clause
• What is Series A funding? A guide for Indian startups
• Anti-dilution protection: full ratchet vs weighted average