Pro-rata rights give investors the option (not the obligation) to invest in a company's future financing round. Pro-rata rights vary in force. They might only apply to the next financing, or to more than one future financings. Most often, those rights are dependent on a certain ownership in the company and thus only granted to larger investors.
Typically pro-rata rights are given to larger investors in rounds. Depending on their strategy, investors may or may not take up their pro-rata rights in subsequent rounds of financing.
As a company finances itself, it dilutes the ownership positions of all investors that have previously invested or earned shares. A pro rata right allows an investor to maintain their ownership percentage in a company. When subsequent financing events (rounds) occur, it allows the existing shareholder of the company to purchase additional shares at the market rate to maintain that same ownership percentage that they had before the financings took place.
An example:
- Investor invests $50K into a company's seed round with a $5M valuation cap
- The investor now owns 1% of the company
- Company raises $3M in a subsequent round at with a $9M pre-money valuation ($12M post)
- If the investor does not participate in the next round, they'll be diluted 25% and will own 0.75% of the company.
- If the investor exercises their pro rata rights and buys 1% of the round ($30K), they will continue to own 1% of the company.
- The "pro rata right" of this investor is the $30K allocation in the subsequent round.
- If the investor wants to maintain their 10% ownership, they would need to buy another 10% of the company.