Below is the “Tip of the Week” transcript from the Podcast Episode 9: Valuation, Ethics and the Midwest Venture Environment p2 (feat. Jeffrey Carter)
On today’s episode, Jeff talked about this concept of optionality of investing. If you remember my discussion with Chris Yeh from Episode 2, we talked about different types of funds. There can be seed funds and growth funds. Seed funds, of course, seeding businesses at an early stage. Growth funds, to invest more, in subsequent rounds, on the winners. Today Jeff talked about raising a $50-100M fund so that he’d have the ability both to seed a range of investments and also “press his winners.” This is a key point that I’ve seen angels omit from some deals. A Key term, that one must include in a venture investment, is called “the pro-rata partcipation right.” Essentially, this allows an early investor to maintain his % of ownership, by providing follow-on capital, at later stages. The reason that this is critical is b/c you can not predict your winners and you need to secure, support and benefit from the early-stage investment that you made. This can also be positive for the entrepreneur. It is a standard term, so it will not alienate VC funding at later stages. It also encourages previous investors to continue making investments in every funding cycle, which can reduce the $ amount that the founder has to raise in those rounds.
Let’s walk through an example. I’m not going to consider liquidation preferences, to keep things simple:
Scenario 1:
YES Pro-Rata Participation Right
Seed Round:
- $500k total raise
- pre-money Valuation: $2M
- post-money Valuation: $2.5M
- 20% total equity stake distributed to investors
Individual Investment:
- $25K investment
- for equity stake of 1%
Series A Round:
- $2M total raise
- pre-money Valuation: $6M
- post-money Valuation: $8M
- 25% total equity stake distributed to investors
Individual Investment:
- $20k (purchase 1% of the $2M raise)
- Maintain an overall stake of 1% equity in the company
No future funding rounds
Exit (simple example w/ no liquidation pref.)
- Company sells to a strategic acquirer:
- Sales Price: $80M
- Cash payout to investor (@ 1% equity): $800,000
- Total individual amount invested: $45k
Scenario 2:
NO Pro-Rata Participation Right
Seed Round:
- $500k total raise
- $2.5M Valuation
- 20% total equity stake distributed to investors
Individual Investment:
- $25K investment
- for equity stake of 1%
Series A Round:
- $2M total raise
- pre-money Valuation: $6M
- post-money Valuation: $8M
- 25% total equity stake distributed to investors
Individual Investment:
- NONE- no pro-rata rights
- Equity stake diluted by 25%
- New equity stake of 0.75%
No future funding rounds
Exit (simple example w/ no liquidation pref.)
- Company sells to a strategic acquirer:Sales Price: $80M
- Cash payout to investor (@ 1% equity): $600,000
- Total individual amount invested: $25k
So, it’s clear to see here, that significant upside was missed, due to the lack of a pro-rata participation right.
You can imagine from this example that if there are a number of future financing rounds an equity stake, in the absence of pro-rata, will dilute significantly.
Now, the corolary here is that one must reserve capital for follow-on financings. A pro-rata does no good if an investor sets-aside a couple hundred grand, makes ten, 20k seed investments and then has no investment capital reserved for subsequent growth financings of seeded startups.
The last piece I wanted to mention is you’ll find that most entrepreneurs are supportive of this provision as they typically want their earliest believers to, at least, have the opportunity to maintain their investment position. That doesn’t mean that they, or future large investors that come in, will allow you to increase your position, but maintaining it through a pro-rata right, is often supported.
So, press those winners and make sure you have the option to press when you make that first investment, by treating Pro-Rata Participation as a right and not a privilege.