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Oct
29

No Pro Rata Investment Rights?

I passed on an investment this week because the terms of the deal didn’t include the right for investors in the current round to maintain their percentage ownership in the company, through additional investment, in future rounds. This is usually outlined in the term sheet, in legalese, as “Preemptive Rights,” “Right of First Refusal” or even “Right of First Offer.” Basically, such a right simply allows early investors to keep themselves from being diluted in future investment rounds. There is no free ride in this situation, of course, the investor must pay for their pro rata share at the next round’s price, just like everyone else. What was particularly troubling about the term sheet in question was that it was pretty clear that the lead investor excluded such rights from the terms in order to have the ability to flush out smaller, early investors in subsequent rounds of financing.

I’ve seen this before (although less frequently over time) and it boggles my mind. Yeah, if you have a boatload of little investments the cap table can be a bit complicated, but that’s just math. Generally speaking, smaller investors don’t have any strong voting rights, board seats or other forms of control so punting on them doesn’t improve the speed or operations of the company. It’s treating form well ahead of function.

So why explicitly exclude or inhibit any investor small or large from investing in your next round? Are you afraid that you might scare off a large, future investor who doesn’t want smaller investors involved financially? Think about it. Are there rational people who would take this position? If so, are these people you want to deal with? To me, the fact that existing investors want to invest more money to retain their ownership is a hugely positive signal indicating that the people who know a lot about the company have faith in its progress and opportunities for success. As an entrepreneur, don’t you want to encourage such behavior?

By not explicitly giving investors pro rata rights (keep in mind that this provision simply grants the investor the right, it’s not a requirement – I’ll write a post on “Pay-to-Play” term sheet weirdness soon), you not only create a problem in subsequent rounds of funding, but you also create a problem now, in the current round. If, as a potential investor, I fear that I may not be able to prevent my dilution in future rounds, how anxious a I going to be to get involved. I’m not. Thus, my exit from the deal this week.

As my long-time friend and corporate general counsel, Peter Johnson, always says, “it’s, at worst, giving them the sleeves of your vest.” “Them,” in this case, being the investors you want to have involved in the company now and, hopefully, in the future.

BTW, there are loads of resources on the web discussing term sheets from many points of view. I highly recommend you take a look at Brad Feld’s and Jason Mendelson’s term sheet series as a starting point.

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 October 29th, 2010  
 Will  
 Investing, Startups, VC  
   
 8 Comments

8 Responses to No Pro Rata Investment Rights?

  1. Hi Will.

    “Boggles the mind” is an understatement.

    I will put my swami hat on and predict — not that long from now we will look back at these couple of years as the brief but painful “angel lunacy era”. Where the aggregate dollars flushed down the toilet pale in comparison to say, the dot com flameout, but the carnage is just as bad — as a generation of young entrepreneurial investors lose not only their capital but their risk tolerance. But hey, they can always reconcile themselves with the comfort that they got to coinvest with blogosphere celebrities and super cool digerati.

    And its odd and troubling how founders and entrepreneurs seem to be drinking the stupid kool aid.

    One should never underestimate how true is the statement:

    “Common sense is a trade secret.”

    • Steve,

      That’s so well said. I couldn’t agree more. Your point about loss of risk tolerance as a result of the cumulative losses will create the ultimate carnage – startup capital will dry up to a great extent.

      “. . . they can always reconcile themselves with the comfort that they got to coinvest with blogosphere celebrities and super cool digerati.” Love it! You mean that rubbing elbows with Dave McClure and Jeff Clavier will only cost me $100K? Where’s my checkbook 🙂

  2. Totally agree Will. Pro rata right is a fundamental right that I always look for.

  3. Will, I agree, but In refering to your term “it’s just math”, it would seem these investors don’t get cleared from the balance sheet, they just become a much smaller percentage, so their say is less and less, effectively turning mosquitoes into gnats. Perhaps this particular lead investor was getting money from his mother-in-law and wanted to not have to listen to her later on….yeh, sure like that would work.

    John

  4. Will, I agree, but In refering to your term “it’s just math”, it would seem these investors don’t get cleared from the balance sheet, they just become a much smaller percentage, so their say is less and less, effectively turning mosquitoes into gnats. Perhaps this particular lead investor was getting money from his mother-in-law and wanted to not have to listen to her later on….yeh, sure like that would work.

    John

  5. What if you had pro-rata rights for any round priced below the (adjusted) price you had paid, but not for up rounds?

    What’s strange about this is that it doesn’t really get rid of the investors – they’re still shareholders, they’re still on the cap table, you still have to do the math, you still have to count them if the company is getting near 500 investors, you still have the SEC reg exposure… what do they really gain at all, unless they’re planning on recapping you into oblivion?

    Let me guess, by the way – east coast terms?

    • You certainly could do something to cover down rounds only, but this is usually covered under antidilutive provisions or elsewhere.

      Yeah, totally strange. I think you hit the nail on the head, Dave. It’s really so that the current investors can flush out the previous investors through a recap. I’ve actually been subject to one of these before – on the short end of the stick. Very messy. Still pisses me off. I’ve never invested again in any company that VC was an investor in and have bad-mouthed then to anyone who has ever approached me asking my opinion of them. A small penalty for them, but I probably cost them something along the way, making me feel infinitesimally better.

      Yes, the terms are from an East Coast investor. I think though that this kinda thing is highly unusual anywhere these days. I just did a deal with a West Coast lead. It looks like the exact same terms as what I see from East Coast leads. Terms have, for the most part, standardized. Greatly, BTW, because of Brad and Jason’s work in this area.

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