
The importance of honoring pro-rata agreements - _sentient
http://www.aaronkharris.com/the-importance-of-honoring-pro-rata-agreements
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austenallred
I've seen this a couple times where the onus is mostly on the later-stage
investors. They know the terms, and they know exactly what they need to say to
lock out the earlier stage investors and take over a bigger portion of the
round, so they start pushing levers to see what they can get to move, playing
on the FUD of the founders that they might not be able to raise from somewhere
else.

What a terrible place to be put in as a company: A big opportunity you're
incredibly excited about, but contingent on you screwing over the people who
have helped get you to where you are in a small way.

I would encourage any founders who are put in this type of scenario to fight
back _hard_. Investors that are worth their while will respect your loyalty
and your refusal to go back on your word. If I were a later-stage investor who
proposed something like that and the company came back strong saying, "That's
not even on the table, because we're not going to do something below the belt"
I would gain additional respect for that company.

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tptacek
I'm not sure this is such a terrible place for founders to be put in. It's
pretty straightforward, as ethical dilemmas go. "Excitement" comes nowhere
close to justifying breaking your word.

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whiddershins
I wonder how straightforward an ethical dilema it is. When signing a contract,
are you ethically obligated to follow the terms of the contract, or are you
merely agreeing to something which can be enforced by the terms of the
contract, including penalties and lawsuits. Most people do business in the
latter way: a contract is only as good as the "teeth" that make it
unprofitable to violate it.

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tptacek
You are ethically obligated to follow the terms of a contract that you
carefully and deliberately sign.

How could it be otherwise? Virtually nobody is in a position to casually and
efficiently use the courts to enforce contract terms.

A contract documents a promise. Promises must be kept.

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founder6564
I am currently on the other side of the table. I have a startup that is doing
well in traffic, but running out of money quickly. I want to sell the company,
and I have several buyers, but my investors who have common stock are
threatening to kill any deal I bring unless they get above and beyond their
pro-rata shares.

At least the investors in this article have the option of not signing whatever
paperwork the new investors push on them. Much harder situation for me as I
risk walking away with nothing unless I give more than our investors are
entitled to.

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3pt14159
Can you share the rough deal size and investor payback? Most investors have 1x
liquidation preference, and I can totally see them getting at least that, even
if they didn't write it into the contract; but if they are asking for more
than 3 or 4x on a short term deal, then they're just being greedy.

~~~
founder6564
I would like to keep it confidential, since my investors likely read HN. Deal
size was above 5 million but less than 10 million. They are pure common, no
liquidation preference or anything like that. For all intents and purposes
they hold the same shares and rights as myself.

They invested more than they would receive in a sale under pro-rata terms, so
they would have a loss, but still a partial return on investment. You say I
should honor terms not written into a contract and give them a 1x preference?
Seems silly to me. If they wanted those terms, they should have negotiated it.
I do not feel entitled to give them more than what they negotiated for. These
guys are a professional fund and this is the name of the game.

Unfortunately, it looks like unless I cave they will just let the company die.
They ultimately know that the sale means much more to me than it does to them.
All the pressure is on me, to end up with 'fuck you' money. They likely do not
care about the money as much as not having to write down a loss or something.
If I was to give them what they want, I would walk away with close to nothing
after having spent significant time working for almost no salary.

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3pt14159
Well here is the truth of the matter: If your investors get their money back
you'll probably get investors again. If your investors do not get their money
back, it will be much harder to raise next time.

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joshu
Pro rata is most important in the case of a down round. Your ownership really
dilutes in that situation.

For what it's worth, I've definitely been asked nicely if I would consider not
taking my prorata because space is needed. When things are THAT tight I am
often asked to sell shares to the new investor as well.

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hglaser
What do you say in those situations?

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joshu
I will do what the founders tell me to do. If I am making their lives more
difficult then I am failing.

Sometimes they ask me to please do take the prorata for optics' sake, too.

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dsjoerg
In some cases this could be angel investors simply not doing what's in their
best financial interest, either short-term or not at all.

If one gets the reputation of always giving up one's pro-rata rights, then you
might as well not have them, right?

It's interesting to consider in what circumstances consenting to surrendering
their pro-rata might be rational behavior.

The surrender is financially equivalent to doing the round at a lower
valuation -- as angel investors have effectively sold their pro-rata rights
back to the founders, who give them to the new investors. However, compared to
simply doing the lower-valuation round, this approach saves more face for the
angel investors.

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joshu
This is somewhere between wrong and irrelevant.

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not_that_noob
This behavior of the VCs towards angels is as old as the hills. They want
control and will screw with anyone who stands in their way. In fact, I have
long speculated that a requirement to make partner at some firms is how smooth
you are when screwing over a founder or angel.

The truth is that the smaller investors don't have leverage. And so they
swallow hard and sign the paperwork. I applaud YC trying to stand up for the
little guy, but I fear they will be unable to fight the seduction of founders
of hotshot companies by big-name big-money VCs whispering sweet nothings into
their ear.

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avemuri
Forgive me if this is a naive question, but why are pro-rata rights considered
standard? It seems like it's essentially the right to dilute founders in the
future to maintain your ownership. Yes you're investing early, but that's
priced into the valuation. I suppose the right has value, so perhaps a lower
valuation would be justified. But why do pro-rata rights always elicit this
moral outrage when called into question?

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patio11
You're conflating two very different sources of moral outrage. One is that,
_prior_ to investors and founders memorializing their agreement on pro-rata
rights in a contract, some investors feel like they're entitled to them
because they're a standard term. One reason why they're standard is detailed
below.

The present controversy is that _after_ investors/founders committed to pro-
rata rights, later investors convinced founders to _not honor those pre-
existing commitments_.

 _Yes you 're investing early, but that's priced into the valuation._

Many investors would say "If you're investing and not getting pro-rata rights,
the valuation you've negotiated is not a meaningful number, because it can be
retroactively renegotiated by parties who do not necessarily have to include
you in that conversation. It is thus not conveniently possible to award
investors with, nor desirable for investors to seek, an attractive valuation
for taking on extra risk by investing early _unless_ that attractive valuation
comes with pro-rata rights."

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avemuri
Agree, you're right on honoring the term once it's been agreed to. Lazy
conflation on my part.

I'm not sure I follow how the valuation is retroactively renegotiated. Later
investors can't dilute an angel unfairly without diluting the founders
unfairly too. In cases where the investor dilutes the angel but issues new
shares to founders, the angel can simply veto the financing, right? Or are you
saying a 5MM premoney valuation with pro-rata rights would be worth vastly
less without pro-rata, so much so, that it's a nonstarter?

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dllthomas
Would it be worthwhile to name-and-shame VCs that are pushing for this?
Knowledge that some VC demands the startups they fund be willing to break
their word should mean startups they fund aren't worth our trust, which should
destroy a lot of their value.

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spinlock
Why would a fund want to participate in a series A with an entrepreneur who
screws their investors? Wouldn't the logical conclusion be to screw the series
A investors when they go to raise a series B?

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danielweber
Because the series A investors have clout and standing with (and may be the
same parties as) the series B investors.

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nasmorn
Let us give the super angels the benefit of the doubt. They probably know that
their pro-rata rights are not always enforceable and price this into the
valuation. Good for them if they can keep them but they are probably at all
surprised if they don't. It is a numbers game for investors.

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GFK_of_xmaspast
Startups are disrupting everything these days.

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jpeg_hero
laughing at the default variables in the spreadsheet. ludicrous the idea that
you can get a 50x return by owning a 1% of a company that was seeded at a $10m
valuation.

....and lets just assume a $1B exit for arguments sake! haha, this guy must be
raising money for a seed fund or something.

\--

oh yeah, and the fact that prorata shares actually cost you something, you
don't get them for free as Aaron seems to think.

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joshu
Indeed.

I often pass on my prorata simply because it would be too expensive to keep up
with, and it would mean not investing in new companies. Since that's the fun
part, I am happy to do that instead.

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vasilipupkin
Theoretically, you could form special purpose vehicles with the intention to
exercise your rights without putting a lot of your own money in. But yeah, I
am with you, on the most successful companies, valuation ends up being too
high for a seed investor anyway

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pbreit
Maybe pro-rata would be more palatable if it was not assignable? It makes
sense to me that early investors get a shot in later rounds. Whether they
should be able to maintain percentages is a different topic. Without ability
to assign, I suspect many might not maintain percentage anyway.

