I recently received a email from an entrepreneur who I know with a genuine question about terms of his financing: “How do you guys at NextView feel about one of our investors holding super pro–rata rights for the next round?” We at NextView Ventures have more recently seen super pro-rata rights introduced by other investors in a couple of the rounds which we’ve participated, and have started to see a pattern emerge of the consequences of this insertion.
On the subject of super pro-rata rights, a couple months ago Brad Feld wrote a blog post “Just Say No” and Mark Suster (after detailed explanation of both pro-rata rights and super pro-rata rights) summed up that the reason not to take them is “you might make it difficult for you to get your company funded in the next round.” Mark’s argument is essentially that they make the entrepreneur’s next fundraise more difficult because of the signal value associated with whether or not the existing VC investor is going to exercise those pro-rata rights.
But the reason that super pro-rata rights aren’t super goes beyond just how that VC with those rights acts as the next round approaches. These rights fundamentally misalign incentives on how the company is operated, which is bad for both an entrepreneur and the VC. The rationale for the negative effects of super pro-rata rights comes down to VC math in which the latter of the three dimensions for the next round – valuation, amount raised, and dilution % – already becomes artificially fixed. So in order to successfully raise at a higher $X valuation, the resulting math requires the round size to be larger. An entrepeneur can be forced to raise more capital (which the business may or may not need) if s/he is going to be rewarded with a higher valuation.
This scenario presents a number of troubling incentives. Prior to the next round, the startup risks being run at a higher burn-rate so that it looks positioned to need the larger financing. Second, an entrepreneur is more likely to be compelled to put a larger dollar-amount “ask” on the cover of his next round’s pitch deck, which can hurt his chances of a successful fundraise if the business isn’t ready yet for a large financing (but would be for a successful smaller one). With super pro-rata rights in play, if an entrepreneur is going to give up a specific % of his company in this round anyway, he’s motivated to make that as large a round as possible – which might not be the right thing for the business as well as decreasing the chances for a successful fundraising process. And then, lastly, even if the larger amount is raised, again, it can over-capitalize the company, which changes the dynamics about how the business is run subsequently. All of these scenarios are not just detrimental to the entrepreneur/startup, but also to the VC funders themselves who want to eagerly invest in a company which is doing well.
I see super pro-rata rights as another VC term-sheet bell & whistle which stem from genuine and legitimate intentions (allowing a VC to own more of a company it likes a lot) that result in misaligned incentives between an entrepreneur, investor, and what is “right” for the business. As a general rule, deviation from a simple and elegant term sheet (especially in early rounds of financing) can cause strain, and super pro-rata rights is just another (new and emerging) example.