Pro rata rights are the most important right for investors. Just ask AVC. While getting a company to agree to pro rata rights is a huge victory, it’s only half the battle. Once you secure pro rata rights, your next task is to make sure they can’t be taken away. This often occurs when they are “waived” on your behalf in connection with an equity financing.
Here’s the scenario:
- You invest in a company at the seed stage and because you’re an early investor, the company agrees to give you pro rata rights indefinitely.
- You own 1% of the company and you want to keep that 1% as the company grows and is more successful.
- The company raises a Series A led by a large Silicon Valley fund and they request 20% of the company post-financing.
- The company only wanted to give away 20% of the company in the Series A so they ask a majority of the investors (which doesn’t include you) to “waive” pro rata rights on behalf of all investors.
- Pro rata rights are waived on your behalf, which isn’t ideal, but at least no one got to exercise their pro rata…
- Except you find out that one of the investors that waived pro rata rights on behalf of all investors is the founder’s “old family friend” so the founder let her participate in the round.
- Now, you’re annoyed because if pro rata rights were waived, no investor should get to exercise them!!
If you have pro rata rights but don't have a majority of the company's preferred stock, you may face this situation. The company can waive pro rata rights for all investors by a majority vote. This is usually achievable with just 2-3 investors, allowing the company to waive pro rata rights for smaller investors with the consent of just a few larger investors.
And if the company is doing really well, you’re going to be angry. You want the opportunity to exercise your pro rata rights so you can maintain your ownership percentage in the company. After all, the success of a few companies accounts for most of a fund’s returns. And you’re going to be even more angry if you find out that some of the investors that waived pro rata rights on your behalf still got to participate in the round.
If you’d like to avoid this situation and the company is using the NVCA documents, here’s what you can do. In the amendment section of the Investors’ Rights Agreement (IRA), there’s language that says a term cannot be waived on behalf of all investors unless the waiver applies equally. However, the waiver of pro rata rights (i.e., the Section 4 reference below) is excluded from the requirement that any waiver must be applied equally. This means that some investors can waive pro rata rights on behalf of all investors and still participate in the round.
Here’s an excerpt of the language:
"... this Agreement may not be amended, modified or terminated and the observance of any term hereof may not be waived with respect to any Investor without the written consent of such Investor, unless such amendment, modification, termination, or waiver applies to all Investors in the same fashion (it being agreed that a waiver of the provisions of Section 4 with respect to a particular transaction shall be deemed to apply to all Investors in the same fashion if such waiver does so by its terms, notwithstanding the fact that certain Investors may nonetheless, by agreement with the Company, purchase securities in such transaction)..."
To avoid this situation, you want to revise the language such that if pro rata rights are waived, but some investors still participate in the round, then all investors get the opportunity to participate.
Here’s an excerpt of the revised language:
"...this Agreement may not be amended, modified or terminated and the observance of any term hereof may not be waived with respect to any Investor without the written consent of such Investor, unless such amendment, modification, termination, or waiver applies to all Investors in the same fashion (it being agreed that an Investor shall not waive the provisions of Section 4 with respect to any other Investor, unless such waiver is applied equally on a pro rata basis to all Investors (and no Investors purchase securities in the transaction to which such waiver is applied, unless all Investors are afford the same opportunity on a pro rata basis))..."
The revised language ensures that if some investors exercise their pro rata, you’re given the opportunity to do so as well. One thing to note is that the pro rata section is often limited to major investors so the revised language above may only apply to major investors and not all investors.
Of course, the revised language won’t apply if pro rata rights are waived and no one gets to participate, but at least the ability to exercise pro rata rights is given (or not) to all investors.
Next time you’re negotiating for pro rata rights, make sure your IRA has the revised language to prevent a scenario where pro rata rights are waived on behalf of all investors, but some investors still get to participate.