Whenever pro-rata rights are involved, you can always smell some drama. When a company raises a financing round, new and old investors often battle it out for the largest stake they can get. While this process can be competitive enough to be considered cutthroat, during the last decade’s bull market, it’s become more or less predictable — new investors generally get their preferred share, while existing backers fight for what they can.
If you’re new to all this, here’s a short explainer: In investing, pro rata is a legal right that allows investors to maintain their ownership stake in a company when it raises capital after they’ve invested. This is critical for early-stage investors and smaller funds, as they can avoid dilution and keep meaningful stakes in their portfolio companies. Traditionally, it hasn’t always been easy for existing investors to exercise this right, as new investors often have the upper hand in fundraises and they can be hungry for a bigger piece of the pie. (If you want to learn more, here’s a more in-depth explanation.)
However, this year is starting to look very different.
“These seed funds went from being told, ‘No, too bad, you aren’t getting your pro-rata’ to, ‘You better cough up some money.'” Loren Straub, GP at Bowery Capital
Venture funding has slowed, with many investors spooked by the current public market volatility or taking a breather after 2021’s funding frenzy. Some startups may still see the same excitement from new lead investors when they look to fundraise, but most won’t.
This means the less lucky startups will likely rely on their existing backers to exercise more or all of their pro-rata allocation. But will their investors even want to do that? It will depend on who they are.
For firms like pre-seed and seed-focused Hustle Fund, which is still deploying capital as usual despite the market’s woes, it’s a welcome change. Eric Bahn, a co-founder and general partner at the firm, said Hustle Fund is glad to be able to increase its share in its predicted winners, which it wasn’t frequently able to do prior to this year.
“The pro-rata allocation is becoming more easy for us to attain, and to get the whole thing,” Bahn told me, speaking about their recent deals. “Now that founders are losing sources of capital, and the aggressiveness of leads is waning, they need to rely a little more on their existing investors.”
Several other early-stage investors confirmed to TechCrunch that they, too, have been seeing more luck accessing their previously promised pro-rata agreements.
But some firms are also feeling pressure to allocate more than they were expecting. Loren Straub, a general partner at seed-focused Bowery Capital, said the firm has felt pressure to make follow-on investments they weren’t planning on, and received, in some cases, “inappropriate” levels of pressure to do so from other investors on the capital table.
“These seed funds went from being told, ‘No, too bad, you aren’t getting your pro-rata’ to, ‘You better cough up some money,'” she said.
Straub predicted Bowery will deploy a lot more capital in these inside rounds than originally expected, but it — like most funds — was not set up to have enough capital to fund every company in its portfolio in that manner. Plus, not every investor will be willing to participate in these inside rounds, as some firms are choosing to sit it out for now.
Stephan Osborn, a member at Mintz law firm, has started to notice this trend. He said he recently worked on a funding round for a startup that he considered was fundraising at a reasonable valuation, and yet multiple investors that were offered their pro-rata allocation declined to exercise.
“It was the first time I saw that in a long time, in a deal where we expected them to take their pro-rata rights. I expect we will see that going forward,” Osborn said. “Some of my founders will be shocked when people don’t take the pro-rata.”
Startups that raised capital from the influx of passive investors last year may have even more trouble, Eric Paley, a co-founder and partner at Founder Collective, predicted. If a startup’s last round was led by a backer like Tiger Global that didn’t take a board seat, they aren’t going to receive as much support in their next round.
“We’ve gone through a period of investors who are very transactional and not necessarily that supportive of companies,” Paley said. “They didn’t want to tie their ego to the company or get on the board. Those companies are going to get very easy to walk away from. They are going to have a hard time getting their insiders to recommit, [which can include exercising their pro-rata rights].”
A passive investor only looking to write a big check probably seemed ideal to founders in last year’s bull market, but many companies may now be having second thoughts about working with these firms if they are now left without guidance or follow-on capital in a downturn.
Osborn echoed this sentiment:
The traditional model was that the people who invested the most money were the closest to you, and would help you raise your next round and participate in that round. They would steer you strategically. The less the investors are doing, the more they look like public company investors who really aren’t involved in the company.
It’s also unclear what role corporate venture firms will play in this environment, Osborn observed. Some corporates may have more trouble getting follow-on investments approved in this environment, while others may receive ample support to continue to diversify or add to their downside protection.
What pro-rata will look like by the end of 2022 is unclear. Investors can’t sit on their hands forever — Bahn noted they can’t collect management fees if they don’t deploy capital. But if things get significantly worse, there may be new market forces at play.
“The duration of the downturn is an enormous driver of what happens,” Paley said. “If people think it’s a relatively quick blip, they will forget about it. But if there is a sense of, ‘Wow, I really don’t know where this is going,’ things get weirder and weirder.”