VCs and founders are debating pro rata rights
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Pro rata rights have long been a standard feature of venture capital deals, but a new startup dispute has sparked debate over whether that should change.
- On one side are fiduciaries. On the other are founders and the founder-friendly.
Terminology: Pro rata rights give existing investors the opportunity, but not the obligation, to purchase a proportional share of new stock in future fundraising rounds (albeit at the new, usually higher, price).
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Driving the news: A nuclear startup named Valar Atomics has sued one of its early investors, Day One Ventures, for trying to enforce their pro rata rights over the company's objections.
- For context, Day One invested in Valar's seed, Series A and Series A extension rounds. The dispute arose on a Sequoia-led Series B round that valued the company at $6 billion.
- Rather than suing quietly and hoping no one would notice, Valar CEO Isaiah Taylor blasted Day One via social media, which of course prompted a response from firm founder Masha Bucher. Thus the ensuing public debate.
The big picture: There are two issues here. The first is a legal one specific to Valar vs. Day One, which Delaware Chancery Court will settle.
- The second is more existential for the future of venture capital as it relates to the future of pro rata rights.
Zoom in: For starters, it's worth recognizing that pro rata rights currently appear in the vast majority of early-stage venture deals. They also are included in the NVCA's model legal documents.
- Supporters argue that early investors take outsized risks and that such protections get priced into the transaction (much like preferred shares). Moreover, pro rata rights are an early-stage investing engine — often returning entire funds — because they allow funds to double down on winners within portfolios that are chock full of failure.
- Opponents argue that pro rata rights only serve to stir conflict — if an investor has proven useful beyond their money, then founders will gladly invite them into future rounds. What's paramount is what's best for the company, which sometimes means diluting early investors for the sake of a deeper or more strategic pocket.
Behind the scenes: The reality is far less binary, as contractual terms often are the starting point for negotiations between founders and existing investors.
- Founders don't want to be known for breaching contracts, while investors don't want to be known for playing hardball. Both have future business relationships to consider.
- One new wrinkle, however, is that some founders are getting pressured on pro rata by growth-stage firms that need to put their billions to work, including via rounds that are tranched by valuation.
The bottom line: Venture capitalists have evolved from firing founders to being their binkies.
- Eliminating pro rata rights, however, might not be as founder-friendly as it appears — possibly reducing the number of early-stage VC funds and, in turn, opportunities for future founders.
