Pro rata rights give investors the right, but not the obligation, to invest in future financing rounds based on their ownership percentage in the company.

Assume an investor with pro rata rights owns 20% of the fully-diluted capitalization after the company’s first financing round. In the subsequent financing round, the company issues 2,000,000 shares of preferred stock and will have a total of 15,000,000 shares outstanding. Using simple math, 20% * 15,000,000 means the investor will need to own 3,000,000 shares to maintain their ownership percentage. If she owned 2,600,000 shares from the previous round, she will need to purchase 400,000 shares in the subsequent financing round to maintain their ownership percentage.

Investing in any company is a risk and the earlier the stage of the company, the riskier the investment. As an incentive to invest in early-stage companies, founders will offer early investors pro rata rights.

Pro rata rights are extremely important for investors because they ensure that early investors can invest more into their most successful portfolio companies. Without pro rata rights, these early investors would likely be completely cut out of investing in the later stages of the company when the financing rounds are often oversubscribed and venture funds request most, if not all, of the financing round as a prerequisite to their investment. 

However, it should be noted that pro rata rights are often cutback or waived as the company grows. So while early investors may have a right pro rata, in practice, it is rarely exercised in later rounds. What can an investor do in this situation? Often very little as venture capital is an industry built on reputation and no investor wants to be known as the investor that held up a round over the inability to exercise her pro rata.

Early in a company’s life cycle, pro rata rights are used as an incentive to convince investors to invest in companies that are pre-product or pre-revenue. Later in a company’s life cycle, pro rata rights are used to incentivize investors to invest a certain amount of money, which is why they are typically reserved for major investors.

In special circumstances, pro rata rights can also be granted separately via side letters.

Typically, pro rata rights only apply to financing rounds, but they can be negotiated in connection with the issuance of SAFEs or convertible notes.

Founders want to limit the types of rounds that pro rata rights apply to, so they typically opt for a more restrictive definition of pro rata rights.

If the company is profitable, investors will want as many opportunities to invest in the company as possible and prefer to have the broadest application of pro rata rights.

Although pro rata rights grant certain investors the right to invest in a company’s next financing round, investors with pro rata rights are not obligated to exercise their pro rata rights unless the company has a “use it or lose it” provision. A “use it or lose it” provision requires the investor to exercise her pro rata or she loses the opportunity to exercise her pro rata right in subsequent financing rounds.

If an investor chooses not to exercise her pro rata rights, the other investors with pro rata rights may have the opportunity to purchase the investor’s unallocated portion. Colloquially this is referred to as “gobble-up rights” or an over-allotment right.

The specifics on when and if a company allows “gobble-up rights” are found in the IRA. While investors will want the right to purchase additional stock if the company is doing well, the company may wish to have greater flexibility around how those shares are allocated. As a result, the over-allotment right may be subject to board approval such that the company has greater control over who owns more equity in the company.

Investors that are able to negotiate pro rata rights may also want to negotiate for additional language around who can waive the pro rata rights. Typically, pro rata rights can be waived by a majority of the investors with such rights. For smaller investors with pro rata rights, this means that pro rata rights can be waived without their approval. And even if pro rata rights are waived on behalf of all applicable investors, sometimes the company will still allow some investors to exercise their pro rata rights in the financing round. One way to prevent this situation is to negotiate for additional language such that if the pro rata rights are waived on behalf of all applicable investors, but some of the investors that waived the rights still participate in the financing round, then all investors with pro rata rights also have the opportunity to participate proportionally in the financing round.