Granting Pro Rata Rights to Convertible Note Investors

Pro rata rights are an investor’s right to invest money in the next round, and in an amount that will maintain the investor’s current ownership percentage. Should you grant pro rata rights to early investors in your startup? You may want to grant a few major investors this extra right, but granting it to all convertible note investors can be dangerous.

While there are good reasons for offering pro rata rights, pro rata rights also can be a problem for startups when it comes time to do the Series A financing, and could affect your ability to bring in a better, bigger fish for the Series A round. The Series A investor (at least, the lead investor) will probably expect to receive around 15-20% of the fully-diluted as part of the Series A investment, and may have a harder time getting to that number if there are a significant amount of noteholders with pro-rata rights. It might lead to you having to give away more of the company to ensure that everyone gets the “percentage” that they want, or potentially allow the noteholders with pro rata rights to be able to block the Series A in a way. When a large number of small investors have pro rata rights, it adds to the administrative cost of the next round, where the company will have to calculate and issue stock to many small investors.

Startups need to be particularly careful about setting up pro rata rights for Convertible Note holders, since the noteholder’s ownership percentage isn’t known yet.

If you decide that it is appropriate to grant certain investors pro rata rights, this can generally be accomplished with a short side letter agreement granting pro rata rights between the company and the applicable noteholders.