Pro Rata

How pro rata works

Pro rata is an allocation rule before it is a venture term. Divide anything in proportion to a stated share and you have pro rated it. A $12,000 annual subscription cancelled after four months refunds $8,000. A dividend paid pro rata pays the same amount per share to every holder.

Venture capital borrows the phrase for one specific right. Stated in words: an existing investor may buy the portion of a new issuance equal to their current ownership percentage, so their percentage after the round matches their percentage before it.

Written as a formula:

Pro rata allocation = current fully diluted ownership percentage x total new shares issued

And the cost of exercising it:

Pro rata investment = pro rata allocation x price per share in the new round

Three details decide what that ownership percentage actually is.

• The denominator. Financing documents measure ownership on a fully diluted, as-converted basis. The agreement language filed with the SEC in NVCA-form deals computes each holder's share as the common stock they hold, counting shares issuable on conversion or exercise of their preferred stock and other derivative securities, over total common outstanding assuming full conversion and exercise of everything then outstanding. A percentage calculated off issued common alone will be too high.
• Who holds the right. Priced rounds rarely give it to everyone. The right of first offer runs to a defined class of Major Investor, and the definition is a share-count or dollar threshold negotiated deal by deal.
• What the right attaches to. New Securities is defined broadly, covering equity securities and anything convertible into them. The carve-outs sit elsewhere: the filed agreement states that the right of first offer does not apply to Exempted Securities as defined in the certificate of incorporation, which is where option pool grants, conversions of existing preferred, acquisition shares and equipment lease and bank warrants are excluded.

Several variants show up in practice.

• Right of first offer, preemptive right and participation right are different names for substantially the same mechanic in priced-round documents.
• Super pro rata gives an investor the right to buy more than their percentage, often a fixed slice of the next round. Founders resist it because it presells part of a round they have not raised yet.
• An overallotment or gobbler provision reallocates the unexercised portion of other Major Investors' rights to those who did exercise, so a committed investor can take more than their own share.
• A pay-to-play provision works in the opposite direction: an investor who declines to take their pro rata in a qualifying round has their preferred stock converted to common, or converted to a shadow series with fewer rights.

A separate use of the phrase is administrative rather than contractual. Management fees, preferred return accruals and distributions are often described as being allocated pro rata among partners according to capital commitments or capital accounts. That is the plain proportional meaning, not a purchase right.

Worked example

Suppose a fund owns 4 percent of a company on a fully diluted basis after a seed round, and the company raises a Series B of $40,000,000 at a $160,000,000 pre-money valuation. All figures below are hypothetical.

Step one: find the post-money valuation. Pre-money of $160,000,000 plus $40,000,000 of new money equals a $200,000,000 post-money valuation. The new round therefore represents 20 percent of the company after closing.

Step two: find the pro rata allocation in dollars. The fund's 4 percent of the $40,000,000 round is $1,600,000.

Step three: check the share math. Assume 20,000,000 shares are outstanding fully diluted before the round, so the fund holds 800,000 of them. A $40,000,000 round priced to buy 20 percent of the company post-closing issues 5,000,000 new shares at $8.00 each. The fund's pro rata is 4 percent of 5,000,000, or 200,000 shares, at $8.00 each, which is $1,600,000. The two routes agree.

Step four: check the ownership outcome. Exercising, the fund holds 1,000,000 of 25,000,000 shares, which is 4 percent, unchanged. Declining, it holds 800,000 of 25,000,000 shares, which is 3.2 percent. The decision costs $1,600,000 and preserves 0.8 percentage points of the company.

Step five: sanity-check against reserves. A fund that wrote a $500,000 seed check now faces a $1,600,000 follow-on, more than three times the original position. This is the reason funds hold reserve capital rather than deploying every dollar at entry, and the reason a small fund can end up unable to afford a right it fought to obtain.

Where it shows up

In a priced equity round, pro rata lives in the Investors' Rights Agreement, not the term sheet alone. The NVCA publishes the model form, and executed versions of it are filed publicly as exhibits to registration statements. Section 4 is titled Rights to Future Stock Issuances, and Subsection 4.1 is the Right of First Offer. The filed language paraphrases as follows: if the company proposes to offer or sell any New Securities, it must first offer those securities to each Major Investor, and each Major Investor may buy up to the portion of the New Securities equal to the proportion that the common stock it holds, including shares issuable on conversion or exercise of its preferred stock and other derivative securities, bears to total common stock outstanding assuming full conversion and exercise. The same section gives each Major Investor twenty days to elect, permits apportionment among affiliates, and ends the right on the earliest of the company's first underwritten public offering, the company becoming an Exchange Act reporting company, or a deemed liquidation event.

Major Investor is a defined term in the same agreement. In one publicly filed NVCA-form agreement the threshold is set at holders of at least 5,500,000 shares of registrable securities, adjusted for splits and recapitalizations. That number is specific to that company's capitalization. What generalizes is the structure: a minimum holding, defined by share count or dollars invested, that separates investors who get the right from those who do not.

In a SAFE round the right is deliberately not in the SAFE. Y Combinator's post-money SAFE contains no pro rata provision. The right is granted, when it is granted at all, in a separate one-page Pro Rata Agreement published alongside the SAFE forms. That side letter gives the investor the right to buy its pro rata share of the standard preferred stock sold in the Equity Financing, and defines that share as the ratio of the shares issued on conversion of all of the investor's post-money-cap SAFEs to the Company Capitalization. The right terminates at the earlier of the initial closing of the equity financing, immediately before a liquidity event, or immediately before a dissolution event, and it cannot be assigned without company consent except to affiliates and related funds.

The term sheet stage usually carries a single line under investor rights reading that major investors will have a pro rata right to participate in subsequent issuances, with the threshold and carve-outs left to the definitive documents.

On the fund side of the business, the phrase appears in limited partnership agreements to describe proportional allocation: capital calls issued to partners pro rata in accordance with commitments, distributions made pro rata, and management fees borne pro rata.

Common mistakes

Confusing a pro rata right with an anti-dilution provision. Pro rata lets an investor spend new money to stay at the same percentage. Anti-dilution adjusts a conversion price without any new money, and only when a later round is priced below the earlier one. They solve different problems.

Calculating the percentage on the wrong base. Ownership for this purpose is fully diluted and as-converted. Leaving out an unissued option pool, outstanding warrants or SAFEs that have not yet converted inflates the number and produces an allocation the company will not honor.

Assuming every investor has the right. Below the Major Investor threshold there is usually no contractual right at all, and small holders are frequently offered participation as a courtesy that can be withdrawn.

Treating the right as transferable. Side letters and the NVCA form both restrict assignment, generally to affiliates and funds under common management. Selling a small position does not carry the pro rata right with it unless the documents say so.

Forgetting that exercising pro rata does not stop dilution from other sources. New option pool shares, later SAFEs and future rounds all dilute. Pro rata holds the line on one issuance only.

Overcommitting reserve capital. A fund that grants itself pro rata across forty seed positions cannot fund all of them. Deciding in advance which positions the reserves are for is part of portfolio construction, not an afterthought.

Confusing pro rata with a pay-to-play obligation. Unless the charter contains a pay-to-play provision, declining to participate costs the investor percentage but nothing else.

Related terms

Pro rata sits next to pro rata rights, which covers the contractual right in more depth, and is best understood alongside dilution, the cap table and post-money valuation, since the percentage being defended is read off the fully diluted cap table. The right is granted in a term sheet and documented in the agreements that accompany a series A or later priced round, and SAFE investors encounter it through the separate side letter that travels with a SAFE. Anti-dilution and liquidation preference are the other two investor protections founders most often confuse with it.

Frequently asked questions

What does pro rata mean in simple terms?

In proportion. If three people own 50, 30 and 20 percent of something and there is $1,000 to divide pro rata, they receive $500, $300 and $200. Every use of the word, from a pro rated refund on a cancelled subscription to a venture investor's right to buy part of a new round, is the same idea applied to a different quantity.

How do you calculate a pro rata share?

Divide the part by the whole to get a proportion, then multiply that proportion by the amount being allocated. For an investment right, the proportion is the investor's fully diluted ownership percentage and the amount is the new round, so the allocation is ownership percentage times total new shares, and the cost is that share count times the new price per share.

Do pro rata rights come automatically with a SAFE?

No. Y Combinator's post-money SAFE does not itself grant pro rata rights. The right is granted through a separate Pro Rata Agreement published with the SAFE forms, and only if the company signs it. An investor who wants the right has to ask for that side letter at the time of the SAFE investment.

Who counts as a Major Investor?

Whoever the Investors' Rights Agreement says. The definition is a negotiated threshold, expressed as a minimum number of registrable shares or a minimum dollar amount invested, and it is set relative to the company's own capitalization. Investors below the threshold typically have no contractual right of first offer.

Should a founder grant pro rata rights?

Most priced rounds include a right of first offer for major investors, and refusing it outright is unusual. The points worth negotiating are the threshold that defines who qualifies, the carve-outs in the definition of New Securities, whether the right survives into later rounds, and whether any investor gets super pro rata, which presells part of a round the company has not yet raised.

What happens to pro rata rights at an IPO?

They terminate. In the filed NVCA-form agreement the right of first offer ends on the earliest of the consummation of the company's first underwritten public offering, the company becoming an Exchange Act reporting company, or a deemed liquidation event. The SAFE side letter terminates at the initial closing of the priced equity financing, immediately before a liquidity event, or immediately before a dissolution event, whichever comes first.