Lee Edwards, partner at Root VC, has a saying at his firm that “pro rata rights are earned, not given.” That may be a bit of a stretch since pro rata refers to a term that VCs put in their term sheets that gives them the right to buy more shares in a portfolio company during consequent funding rounds to maintain an ownership percentage and avoid dilution.
Still, while these rights are not exactly “earned,” they can be expensive. One of the latest trends in VC investing these days are funds dedicated to helping seed VCs exercise their pro rata rights.
The problem is that in later rounds, the new lead investor will usually get its preferred allocation. Meanwhile, other new investors try to get what they can while existing investors have to pony up whatever the lead has agreed to pay per share if they want to exercise their pro rata rights.
And, often, the new investors would prefer to squeeze pro rata investors out of the round altogether and take more for themselves. Meanwhile, founders want to cap the total chunk of their company they will sell in the round.
“It’s pretty common that a downstream investor will want to take as much of the round as they want, and will sometimes tell the founder they need an allocation that’s so large, it wouldn’t leave room for pro rata rights — essentially telling the founder to ask earlier investors if they would willingly waive their pro rata rights,” Edwards told TechCrunch.
Earlier investors often have to rely on the founder “going to bat for us and pushing back on that request,” which will only happen if the investors provide enough value that they feel comfortable negotiating on the earlier investors’ behalf, he said.
Securing capital to stay in the game
Sometimes venture capitalists don’t choose to exercise their pro rata rights. While they obviously might pass on buying more shares in a struggling startup, they are often forced to pass up buying more of their winners, too, because they can’t afford them.
Between 2020 and 2022 — during the VC investing frenzy years, for example — Edwards saw a lot of early-stage funds decline to exercise pro rata on later-stage rounds due to what he called “eye-popping valuations.”
Indeed, new investors in later rounds often run bigger funds than seed investors and can pay more per share, making it tough for early-stage investors and smaller funds to keep participating in later rounds.
This is where investment companies like Alpha Partners, SignalRank and now SaaS Ventures come in. All three deploy capital at the Series B level and later rounds to support seed-stage and Series A VCs who want to exercise their pro rata rights.
“When, for example, Sequoia invests in a Series A, other existing investors can participate,” SaaS Ventures partner Jesse Bloom told TechCrunch. “However, if you want to get in on the Series B, you have to be invited by Sequoia, the founder or were involved in the Series A. My job is to hear from my network that it is happening and find Series A investors and offer to stake them in their pro rata. I give them money to invest in their pro rata, and I get 10% of the carried interest.”
Most, if not all, of the names on the list of top-tier VC firms Bloom monitors for later-stage deals are those you recognize, from Andreessen Horowitz to Insight Partners to Valor Equity Partners.
He is also able to make quick decisions because, if a top-tier VC fund is leading a deal, he said he doesn’t have to do as much diligence, saying, “That’s the only way I can get in — I’m betting on the unfair advantage of the top guys.”
That’s another reason why he only invests in deals led by a list of the top 25 VC funds listed on its website, Bloom said. “We believe access beats diligence in the long run in later-stage venture capital and will do whatever it takes to gain access to deals led by our top funds, even if it means we don’t know as much about the company,” he said.
Bloom previously worked at Alpha Partners before SaaS Ventures leaders Collin Gutman, Brian Gaister and Seth Shuldiner hired him to raise a fund for them that would compete with Alpha.
He has now closed a new fund for SaaS Ventures with $24 million in capital commitments to invest in those pro rata opportunities. The new fund limited partnership is anchored by Pennington Partners, which manages multiple family offices. It is also backed by registered investment advisors who understand the advantages had by the large venture capital firms but are often unable to get in at the higher ticket sizes, Bloom said.
Bloom has made five deals already, including Apollo.io’s Series D and MaintainX’s Series C, both led by Bain Capital Ventures; Cover Genius’s Series E led by Spark Capital; and Elisity’s Series B round led by Insight Partners.
Pro rata boom
Bloom’s not alone in finding success for pro rata-targeted funds. Keith Teare’s SignalRank is going after a $33 million fund that it started raising in January, according to an SEC filing. Alpha is also raising a new fund to target pro rata, according to Steve Brotman, managing partner at Alpha Partners. The firm secured just over $125 million in capital commitments, and he expects to close at the end of July with over $150 million.
For many of the early investors on a company’s cap table, since many of them write $1 million to $3 million checks, pro rata is traditionally the only way they can get into these bigger deals, Bloom said. Similarly for founders, this type of deal supports their existing investors.
“We are essentially the LPs of their existing investors so they can have pro rata rights of anti-dilution,” he said. “At some point, the founders are going to cut out existing investors, so I give them access to very cheap and quick capital.”
As Root VC’s Edwards mentioned, two years ago, investors weren’t rushing to make pro rata deals. Today, that seems to be a different story. The pro rata game is heating up, according to Bloom and Brotman, who say much of this is coming from fewer deals being done at later stages, so there is more of a challenge getting access to those big-ticket deals.
In the first quarter of 2024, $9.3 billion in capital was raised by VCs across 100 U.S. funds, which is just 11.3% of the $81.8 billion raised in the 2023 market, according to PitchBook-NVCA Venture Monitor.
Investors said this leaves an abnormally high number of VCs unable to fund their pro rata rights. In fact, Brotman says as much as 95% of the time, investors aren’t doing their pro rata.
“Pro rata rights and opportunity funds really boomed out in 2021 and 2022, then in 2023, there started to be a downward trend,” he told TechCrunch. “In 2024, very few funds are being raised by small funds. LPs are figuring this out. They did a lot of co-investing in 2022, and 2021 and got their asses burned, honestly, because they rushed in at massive valuations.”
He likened it to playing the card game Blackjack and if you have a certain hand, you can double down on your bet, depending on what the dealer is showing. “If you don’t double down when you can, the house wins. The same is true in venture capital, but no one’s bothered to talk about it,” he told TechCrunch.
Well-known angel investor Jason Calacanis, founder and CEO of Inside.com and Launch, sat down with Brotman in May for his podcast, “Driving Alpha,” and told Brotman how if he had utilized his pro rata follow-on rights in his first fund, he could have tripled the returns, which already achieved a 5x return. So why didn’t he?
“Well, back in that day, you were trying to use your 100 swings at bat, or in the case of this $10 million, 109 swings, to hit one outlier based on the Power Law,” Calacanis said. In this case, the “Power Law” is where one single investment yields returns larger than all other investments combined.
Among institutions and family offices, risk and duration are affected right now, with duration “really being the killer,” Brotman said. Many of these institutions don’t have 10 to 15 years to prove their worth — more like three to six years, he said.
Venture capitalists need to double down on their winners and speak with their founders about why it’s important they do so. Also, if they can do their pro rata rights, they can often stick around on the board, which is important for early VCs, Brotman said.
“A big component of being a venture capitalist is being able to ride your unicorns,” he said. “Even if they’re not on the board, the fact that they’re investing, the CEO still will spend more time with them and answer their calls.”
