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Venture capital financing: Investor's right to take part in subsequent rounds (pro rata right)

legal updates
19 / 01 / 2024

The substance of a pro rata right

For convenience purposes, let’s look at what the pro rata right is using a simple example. Let’s hypothetically imagine a situation that you are the managing partner of a venture capital fund and you negotiate the terms of investing in Zoom, a company developing online conference products. Let’s assume you are planning to invest USD2 million during a seed round, with the company being valued at USD10 million (a pre-money valuation). For an investor, this value looks attractive and you are pleased with the closing round. As a result of the round, your share will be 16.7%.

As a professional investor, you also understand that if the company grows faster than you expected, you will be ready to invest more money in it at a higher value at round A or subsequent rounds by joining other investors of such round. In order for the investor to be able to buy the stock of the company at a subsequent round together with other stockholders, the investor’s relevant right (pro rata right) should be stipulated in the transaction documents at the current round (at the seed round in our example).

The importance of the pro rata right to the investor

The pro rata right allows the investor to maintain the size of its share even after the completion of the subsequent rounds of financing (by taking part in them) and to prevent the significant dilution of the share (we addressed the issue of share dilution in more detail in Issue 2). Accordingly, by maintaining its share at quite a high level (16.7% in our example) and preventing its dilution at subsequent rounds, you will secure a good return on the investment for your venture capital fund if the company is successful in the end, and it makes it to an IPO or is sold to a strategic investor.

Maintaining a share in the company capital at a high level may be of importance to an investor in terms of its influence on the company operations and taking managerial decisions: for example, the right to appoint a member of directors often depends on how much stock of a particular class the investor holds.

The importance of the pro rata right to the company

For the company and founders, the investor’s right to take part in the new round is of importance for two reasons as a minimum. First, the founders will be able to understand who will invest in the next round. Even though the pro rata right is an investor’s right rather than an obligation, the founders may be interested in taking part in the subsequent rounds of earlier investors who are benefiting the company.

Second, it is important that the founders should thoroughly choose candidates to become investors who will be granted the pro rata right (which is a standard right for venture capital deals). As a reminder, the financing round cannot be “endless” as investments are made at a certain value and to a certain amount. In practice, a so-called “oversubscription” may indeed sometimes occur. This is when the number of those wishing to invest is bigger than the amount of investment sought. If the contribution of earlier investors is exclusively financial and they do not bring any other benefit to the company (for example, they do not participate in taking strategy decisions and securing business contacts), their participation in the next round is less desirable as the company will have to deny participation to more preferrable investors.

In our practice we have come across a viewpoint expressed by both investors and founders that the investors’ circle with pro rata rights must be limited and the granting of a pro rata right should be cancelled as a standard condition of venture capital deals. The reason is that most of the earlier investors regard their investment as being purely financial and do not bring added value to the company. At the same time, founders often assume that the investor will take part in the life and development of the company not only with its capital, but will also help with business contacts, taking strategy decisions and carrying out subsequent rounds. However, so far, we have seen that the granting of a pro rata right to investors still remains a standard for venture capital deals and in the vast majority of term sheets that investors send to companies this right is included.

Limitations on the pro rata right

In the term sheet, the pro rata right may be formulated differently and may include various qualifications and limitations. Let’s look at some examples:

  • A limitation on participation in subsequent rounds: in subsequent rounds, the right to participate in new rounds may be granted only to the most important group of investors (so-called Major Investors). This means that earlier investors may forfeit their pro rata right as additional capital is raised.
  • A limitation on quantity: usually, an investor who received a pro rata right is limited in the number of company stocks it can purchase in the next round. Usually, the pro rata right is proportionate to the investor’s stockholding (this is where the name pro rata stems from, which means “in proportion to”). In our example, the investor received a share of 16.7% in the capital of Zoom; consequently, in the next round the investor will have a right to purchase such number of the next round stocks so that its share remains equal to 16.7% of the increased company capital. In other words, the investor will need to purchase 16.7% of the new round stocks.

    Such a pro rata limitation has a reverse side though: it may be that the investor will purchase not all of the stock it is entitled to, but when planning the round the company should assume that this number of stocks may be bought by the investor, ie the investor must be given the opportunity to do so. Even if there were prior arrangements with earlier investors, it is not always that they use up their pro rata right to a full extent.

    In transaction documents you can come across even more aggressive provisions stipulating the right of earlier investors to purchase all new round stocks. In such case, the previous round investors may not only maintain, but also increase their share in the company.
  • Pay-to-play provisions: this limitation provides that the investor forfeits its right to participate in the new rounds if it has not used up its pro rata right during the previous round. Sometimes the term sheet provides that in this case the investor forfeits its other privileges. For example, part of its preferred stock may be converted to common stock and the investor will forfeit a number of advantages. This is quite an aggressive provision in relation to investors and is seldom found, for example, in the financing of technology companies, but it is more characteristic of venture capital investments in biotech companies and life sciences projects. This is connected with the longer development cycle of new drugs, medicines, medical and health solutions, which requires higher guarantees of subsequent financing.

Oversubscription clauses

Often the provisions of transaction documents stipulate a right of the investor who did not express a wish to purchase all stock by using its pro rata right to additionally purchase the stock that was not purchased by other investors through the exercise of their pro rata right. We are referring to a so-called oversubscription or gobble up clause.

Let’s revert to our example where you as an investor in Zoom hold a share of 16.7%. Let’s assume that other investors with a share of 4% took part in the previous round. The investors’ aggregate share will, accordingly, equal 20.7%. Let’s assume you have the right to purchase a proportionate number of stock, ie 16.7% of newly issued stock. For example, you state that you are ready to purchase 16.7% of the new round stock, but other stockholders do not express their wish to take part in the new round. If the documents contain a gobble up (oversubscription) clause, the company must also offer this 4% to you.

However, companies are often against including such clause in the documentation as it causes lengthy uncertainty about the number of stocks that may be offered to new investors.

Documenting the pro rata right

Legally the pro rata right is usually formulated as an obligation of the company to offer the newly issued stock to investors or a group of investors. In this case investors are given a certain amount of time to declare their wish to purchase the newly issued stock or a refusal to purchase.

When a deal is governed by the law of the state of Delaware, the pro rata right is usually stipulated in an Investors’ Rights Agreement, an agreement on the rights of the investor. If we are speaking of a European deal, the pro rata right is most likely to be documented in a Shareholders Agreement or in the company’s constitutional documents. For more details on these documents, please refer to Issue 2. In the model documents of the National Venture Capital Association (NVCA), you can also find the relevant provisions (provisions on the right to future stock issuances).

The model documents devised by the British Private Equity & Venture Capital Association (BVCA) also provide for a pro rata right, but this right is usually set out in the company’s articles of association. The wording of the articles of association looks similar: the pro rata right is formulated as the obligation of the company to offer newly issued stock to previous investors.
As the pro rata right is formulated as the obligation of the company, this obligation is often subject to certain conditions. For example, common and relevant now is the condition that a company is not obliged to offer newly issued stock to an investor if it is subject to any sanctions. Therefore, if the investor becomes a sanctioned person, it forfeits the right to participate in the new rounds of financing.

The pro rata right in Russian law governed deals

A traditional problem for Russian law governed deals is the enforceability of the negotiated arrangements that are standard for venture capital deals, since the regulation concerning the operations of joint stock companies is not sufficiently dispositive and other relevant legal instruments are not expressly stipulated by Russian law.

In addition, in Russia, there are no such organisations as the NVCA or BVCA that would aggregate the interests of market actors and work on creating model documents subject to the specifics of Russian law. However, development institutions do develop various standard documents that can be used by market actors to simplify the process of negotiating the terms of transactions under Russian law. For example, the Internet Initiatives Development Fund (IIDF) devised a model set of documents for investment deals.

The IIDF’s model corporate agreement contains provisions on the rights of investors to take part in new investment rounds and on the responsibilities of all participants to ensure this right (to do everything in their power). It is advisable that when negotiating Russian law documents, you provide for additional mechanisms to ensure the enforceability of such right (for example, a right to veto an increase in the authorised capital under certain conditions). Otherwise, the enforceability of such provision of the corporate agreement on the investor’s right to participate in the new rounds will be rather questionable.

In the next issue we will talk about how the board of directors is formed in a company that received venture capital investments.