The importance of honoring pro-rata agreements

http://www.aaronkharris.com/the-importance-of-honoring-pro-rata-agreements

by _sentient • 12 years ago

71 56 12 years ago

I've seen this a couple times where the onus is mostly on the later-stage investors. They know the terms, and they know exactly what they need to say to lock out the earlier stage investors and take over a bigger portion of the round, so they start pushing levers to see what they can get to move, playing on the FUD of the founders that they might not be able to raise from somewhere else.

What a terrible place to be put in as a company: A big opportunity you're incredibly excited about, but contingent on you screwing over the people who have helped get you to where you are in a small way.

I would encourage any founders who are put in this type of scenario to fight back hard. Investors that are worth their while will respect your loyalty and your refusal to go back on your word. If I were a later-stage investor who proposed something like that and the company came back strong saying, "That's not even on the table, because we're not going to do something below the belt" I would gain additional respect for that company.

founder65644• 12 years ago

Keep in mind that unless the existing investors actually sign something agreeing to this, it cant happen. Many likely do sign, because they think that getting big-namebrand-investor onboard is worth the haircut. If they don't want to do it, they don't have to. If the company does it anyways, they would have a slam dunk legal case to reclaim their ownership. Majority shareholders diluting minority shareholders for their own benefit is probably the most common business dispute there is.

7Figures2Commas7• 12 years ago

Founders realistically have to pick and choose their battles. If a founder raises a seed round from 10 investors who each invest a five figure amount, and eight of those 10 investors do little to nothing after writing a check, it's difficult to expect the founder to go to bat for them if push comes to shove.

tptacek6• 12 years ago

Are you sure you're not moving the goalposts here, like, a lot? If you make a promise, keeping it doesn't constitute "going to bat for someone".

ScottBurson• 12 years ago

If you want to write a contract to the effect that the investor retains pro rata rights provided he/she does X, Y, and Z, you can certainly do that. If the contract doesn't say that, then that wasn't your agreement.

-- Ah, I understand. Your comment is addressed to the seed investors, not to the founders. As such, it's a fair point. The question of how the investors should behave is not what we're discussing, though.

tptacek6• 12 years ago

I'm not sure this is such a terrible place for founders to be put in. It's pretty straightforward, as ethical dilemmas go. "Excitement" comes nowhere close to justifying breaking your word.

chimeracoder2• 12 years ago

It's pretty straightforward, as ethical dilemmas go. "Excitement" comes nowhere close to justifying breaking your word.

Agreed - this is inexcusable.

If you lose an investment because a later-stage investor is keen on you cheating existing investors out of what you already promised them, I'd say you dodged a bullet - you don't want them owning any piece of your company.

If your later-stage investors are so keen on working with investors who are willing to renege on their promises and legal obligations to earlier investors, that says something about:

(A) The types of entrepreneurs they want to work with

(B) How they themselves can expect to be treated in later rounds, when they are now the "earlier investors".

tomp2• 12 years ago

It's straightforward as an ethical dilemma, but maybe not as a practical/CEO dilemma. Are you willing to risk the future of your company, your employees and finally, your own future (by failing to raise another round) on keeping your word?

Now, of course, if it's such a hot startup that investors are cramming to get into a round, it probably less of a dilemma. But that might not always be the case.

whiddershins• 12 years ago

I wonder how straightforward an ethical dilema it is. When signing a contract, are you ethically obligated to follow the terms of the contract, or are you merely agreeing to something which can be enforced by the terms of the contract, including penalties and lawsuits. Most people do business in the latter way: a contract is only as good as the "teeth" that make it unprofitable to violate it.

shalmanese• 12 years ago

This has traditionally been the role of unions and why YC has morphed itself into a de-facto founders union to better negotiate terms like this across a collective of founders.

otakucode• 12 years ago

I wouldn't be surprised if this sort of thing were a test. If you're not willing to screw over the earlier investors, you are clearly not ready to manage a large company. Large companies run on 'if I don't do it a competitor will and then we'll lose', not on being good people. Especially considering that white collar crime is very rarely punished, and then only with a slap on the wrist, such crime is expected in such circles.

founder65644• 12 years ago

I am currently on the other side of the table. I have a startup that is doing well in traffic, but running out of money quickly. I want to sell the company, and I have several buyers, but my investors who have common stock are threatening to kill any deal I bring unless they get above and beyond their pro-rata shares.

At least the investors in this article have the option of not signing whatever paperwork the new investors push on them. Much harder situation for me as I risk walking away with nothing unless I give more than our investors are entitled to.

3pt141592• 12 years ago

Can you share the rough deal size and investor payback? Most investors have 1x liquidation preference, and I can totally see them getting at least that, even if they didn't write it into the contract; but if they are asking for more than 3 or 4x on a short term deal, then they're just being greedy.

founder65644• 12 years ago

I would like to keep it confidential, since my investors likely read HN. Deal size was above 5 million but less than 10 million. They are pure common, no liquidation preference or anything like that. For all intents and purposes they hold the same shares and rights as myself.

They invested more than they would receive in a sale under pro-rata terms, so they would have a loss, but still a partial return on investment. You say I should honor terms not written into a contract and give them a 1x preference? Seems silly to me. If they wanted those terms, they should have negotiated it. I do not feel entitled to give them more than what they negotiated for. These guys are a professional fund and this is the name of the game.

Unfortunately, it looks like unless I cave they will just let the company die. They ultimately know that the sale means much more to me than it does to them. All the pressure is on me, to end up with 'fuck you' money. They likely do not care about the money as much as not having to write down a loss or something. If I was to give them what they want, I would walk away with close to nothing after having spent significant time working for almost no salary.

phreanix• 12 years ago

Just wondering, why sell and not raise additional funding? Or is that something you already explored?

founder65644• 12 years ago

Not a option for a bunch of reasons.

emmett• 12 years ago

Hey, I think you might be slightly confused on some terminology.

Pro-rata is about investing MORE money into the company when you raise a round, to avoid being diluted. It's not something you can get "above".

I think you're talking about liquidity preferences here, which are a separate issue. You could get returns "above and beyond" liquidity preferences, so I'm guessing that's what your investors are actually talking about.

dsjoerg• 12 years ago

In some cases this could be angel investors simply not doing what's in their best financial interest, either short-term or not at all.

If one gets the reputation of always giving up one's pro-rata rights, then you might as well not have them, right?

It's interesting to consider in what circumstances consenting to surrendering their pro-rata might be rational behavior.

The surrender is financially equivalent to doing the round at a lower valuation -- as angel investors have effectively sold their pro-rata rights back to the founders, who give them to the new investors. However, compared to simply doing the lower-valuation round, this approach saves more face for the angel investors.

joshu4• 12 years ago

This is somewhere between wrong and irrelevant.

jpeg_hero• 12 years ago

laughing at the default variables in the spreadsheet. ludicrous the idea that you can get a 50x return by owning a 1% of a company that was seeded at a $10m valuation.

....and lets just assume a $1B exit for arguments sake! haha, this guy must be raising money for a seed fund or something.

oh yeah, and the fact that prorata shares actually cost you something, you don't get them for free as Aaron seems to think.

joshu4• 12 years ago

Indeed.

I often pass on my prorata simply because it would be too expensive to keep up with, and it would mean not investing in new companies. Since that's the fun part, I am happy to do that instead.

vasilipupkin• 12 years ago

Theoretically, you could form special purpose vehicles with the intention to exercise your rights without putting a lot of your own money in. But yeah, I am with you, on the most successful companies, valuation ends up being too high for a seed investor anyway

7Figures2Commas7• 12 years ago

Yes, the numbers are absurd. I feel sorry for LPs in any seed fund run by somebody who is handing out $10 million valuations.

As for the $1 billion exit, according to CB Insights, in 2013, 19 tech companies went public or were acquired at a billion-plus valuation. That represents slightly more than 1% of all exits. Over 70% of the exits were under $200 million. So any angel banking on billion dollar exits would probably be better off going to Vegas.

akharris• 12 years ago

See Paul's comment above - not really sure why this is absurd. The vast majority of venture returns are in the extreme long tail outcomes.

paul• 12 years ago

Why is that ludicrous? I've gotten > 50x return multiple times. If you invest in winners, it's not unreasonable -- that's where most of the money is made in this business, and why it matters to not get squeezed out of the big hits.

joshu4• 12 years ago

Pro rata is most important in the case of a down round. Your ownership really dilutes in that situation.

For what it's worth, I've definitely been asked nicely if I would consider not taking my prorata because space is needed. When things are THAT tight I am often asked to sell shares to the new investor as well.

hglaser• 12 years ago

What do you say in those situations?

joshu4• 12 years ago

I will do what the founders tell me to do. If I am making their lives more difficult then I am failing.

Sometimes they ask me to please do take the prorata for optics' sake, too.

not_that_noob• 12 years ago

This behavior of the VCs towards angels is as old as the hills. They want control and will screw with anyone who stands in their way. In fact, I have long speculated that a requirement to make partner at some firms is how smooth you are when screwing over a founder or angel.

The truth is that the smaller investors don't have leverage. And so they swallow hard and sign the paperwork. I applaud YC trying to stand up for the little guy, but I fear they will be unable to fight the seduction of founders of hotshot companies by big-name big-money VCs whispering sweet nothings into their ear.

spinlock• 12 years ago

Why would a fund want to participate in a series A with an entrepreneur who screws their investors? Wouldn't the logical conclusion be to screw the series A investors when they go to raise a series B?

danielweber2• 12 years ago

Because the series A investors have clout and standing with (and may be the same parties as) the series B investors.

avemuri3• 12 years ago

Forgive me if this is a naive question, but why are pro-rata rights considered standard? It seems like it's essentially the right to dilute founders in the future to maintain your ownership. Yes you're investing early, but that's priced into the valuation. I suppose the right has value, so perhaps a lower valuation would be justified. But why do pro-rata rights always elicit this moral outrage when called into question?

pbreit2• 12 years ago

If the pro-rata rights exist, it's seems obvious that trying to void them is at least unethical.

But pro-rata rights make perfect sense to me. I don't see it as "the right to dilute founders" but more "thanks for taking a risk on us when it was far from clear that things might work out...I know your economics necessitate a follow on like this".

avemuri3• 12 years ago

Agreed on the first point, I didn't mean to say honoring the contract is up for debate.

On the second, yeah I'd want my helpful early investors to continue to be meaningfully invested. But what about unhelpful ones? I guess I'm asking why is it standard to promise this right before you've worked with an angel. The angel took a risk, but that risk was priced into the valuation in theory.

I'm in India. A ROFR was also once considered standard here. "We took the early risk, so we should get first dibs on the whole round." That went south because it was jeopardizing fundraising and angels didn't have deep enough pockets to do whole Series As anyway. I guess I'm applying the same logic there. If a pro-rata jeopardizes fundraising and causes all these headaches, why not just take it out and adjust the angel round valuation accordingly.

patio11• 12 years ago

You're conflating two very different sources of moral outrage. One is that, prior to investors and founders memorializing their agreement on pro-rata rights in a contract, some investors feel like they're entitled to them because they're a standard term. One reason why they're standard is detailed below.

The present controversy is that after investors/founders committed to pro-rata rights, later investors convinced founders to not honor those pre-existing commitments.

Yes you're investing early, but that's priced into the valuation.

Many investors would say "If you're investing and not getting pro-rata rights, the valuation you've negotiated is not a meaningful number, because it can be retroactively renegotiated by parties who do not necessarily have to include you in that conversation. It is thus not conveniently possible to award investors with, nor desirable for investors to seek, an attractive valuation for taking on extra risk by investing early unless that attractive valuation comes with pro-rata rights."

avemuri3• 12 years ago

Agree, you're right on honoring the term once it's been agreed to. Lazy conflation on my part.

I'm not sure I follow how the valuation is retroactively renegotiated. Later investors can't dilute an angel unfairly without diluting the founders unfairly too. In cases where the investor dilutes the angel but issues new shares to founders, the angel can simply veto the financing, right? Or are you saying a 5MM premoney valuation with pro-rata rights would be worth vastly less without pro-rata, so much so, that it's a nonstarter?

danielweber2• 12 years ago

The angel has little power against later VC rounds besides the protections he negotiated for upfront. Since it's purely in the VC's interest to screw the angel, the angels make it a standard to negotiate this protection. And of course people get upset when a negotiated protection is tossed aside.

nasmorn• 12 years ago

Let us give the super angels the benefit of the doubt. They probably know that their pro-rata rights are not always enforceable and price this into the valuation. Good for them if they can keep them but they are probably at all surprised if they don't. It is a numbers game for investors.

GFK_of_xmaspast• 12 years ago

Startups are disrupting everything these days.

dllthomas• 12 years ago

Would it be worthwhile to name-and-shame VCs that are pushing for this? Knowledge that some VC demands the startups they fund be willing to break their word should mean startups they fund aren't worth our trust, which should destroy a lot of their value.

The importance of honoring pro-rata agreements

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