What are Pro-Rata Participation Rights?

Pro-rata participation rights, or pro-rata investing rights, guarantee existing investors the right to participate in future fundraising activities. Pro-rata participation rights allow private investors to maintain and/or expand their share of a business by participating in future funding rounds. As a result, the rights allow private investors to protect against a loss of control stemming from an inflow of new investors.

 How They Work

Consider the following example: A private equity investor just put in $10 million into a tech start-up for a 25% share of the business. If the investor is guaranteed pro-rata participation rights, then he is given the right to participate in future rounds of funding where the investor can choose to maintain his 25% share or to increase his share beyond 25%.

Pro-rata participation rights don’t guarantee that an investor will be able to maintain and/or expand their share of the business. It simply guarantees that an investor will be given the opportunity to maintain and/or expand their share of the business. For example, an investor with such rights might get priced out by other investors in future funding rounds. The rights are typically offered to investors who are willing to commit larger amounts of capital. 

Types of Pro-Rata Participation Rights

 1. Full Rights to Funding

Full pro-rata participation rights give private investors the right to increase their share of a business by taking part in future fundraising activities.

 2. Partial Rights to Funding

Partial pro-rata participation rights give private investors the right to maintain their share of a business by taking in part in future fundraising activities.

 Illustrative Example – Pro-Rata Participation Rights

A tech startup raises $10 million capital in its first round of funding. A private investor put in $100,000 for a 1% share in the start-up. The tech start-up also guaranteed partial pro-rata participation rights for its next round of funding to all investors who put in at least $50,000 in the first round and full pro-rata participation rights for its next round of funding to all investors who put in at least $2,500,000 in the first round.

After increasing its capital to $15 million, the start-up holds another round of funding for $5 million. Let us calculate what amount the private investor is entitled to buy.

At the start of the second round of funding, the investor owns 1% of a $15 million business. Therefore, the investor’s initial $100,000 investment increases by 50%. It is not surprising given that the business has grown by 50%. If the investor chooses to not participate in the second round of funding, he would own $150,000 of a $20-million business or 0.75%.

Pro-rata participation rights guarantee the investor the right to maintain his 1% share in the business. It means that the investor has the right to $50,000 (or 1% of the second round of funding) to maintain his 1% share of the business. Consider a second private investor who invested $5 million for a 50% share in the same tech startup. At the start of the second round of funding, the investor owns 50% (or $7.5 million) of the $15-million business. The investor has the right to take part in the next round of funding and increase his share of the business. If the investor purchases the entire amount, he will increase his share in the business by 25% from 50% to 62.5%.