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The importance of honoring pro-rata agreements

aaronkharris.com

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Re: The importance of honoring pro-rata agreements

#41

Post by avemuri »

patio11 wrote: post #33
avemuri wrote: post #30

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 questi…

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 f…

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?

Re: The importance of honoring pro-rata agreements

#42

Post by emmett »

founder6564 wrote: post #3

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 inv…

Hey, I think you might be slightly confused on some terminology.

Pro-rata is about investing MORE money into the company when you raise a round, to avoid being diluted. It's not something you can get "above".

I think you're talking about liquidity preferences here, which are a separate issue. You could get returns "above and beyond" liquidity preferences, so I'm guessing that's what your investors are actually talking about.

Re: The importance of honoring pro-rata agreements

#43

Post by tptacek »

whiddershins wrote: post #39
tptacek wrote: post #10

Earlier quoted context omitted.

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.

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.

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.

Re: The importance of honoring pro-rata agreements

#44

Post by avemuri »

pbreit wrote: post #32
avemuri wrote: post #30

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 questi…

If the pro-rata rights exist, it's seems obvious that trying to void them is at least unethical. But pro-rata rights make perfect sense to me. I don't see it as "the right to dilute founders" but more "thanks for taking a risk on us when it was far from clear that things might work out...I know your economics necessitate a follow on like this".

Agreed on the first point, I didn't mean to say honoring the contract is up for debate.

On the second, yeah I'd want my helpful early investors to continue to be meaningfully invested. But what about unhelpful ones? I guess I'm asking why is it standard to promise this right before you've worked with an angel. The angel took a risk, but that risk was priced into the valuation in theory.

I'm in India. A ROFR was also once considered standard here. "We took the early risk, so we should get first dibs on the whole round." That went south because it was jeopardizing fundraising and angels didn't have deep enough pockets to do whole Series As anyway. I guess I'm applying the same logic there. If a pro-rata jeopardizes fundraising and causes all these headaches, why not just take it out and adjust the angel round valuation accordingly.

Re: The importance of honoring pro-rata agreements

#45

Post by chimeracoder »

whiddershins wrote: post #39
tptacek wrote: post #10

Earlier quoted context omitted.

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.

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.

> 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.

Ethics have nothing to do with the likelihood of getting caught or any potential penalties after being caught.

Some people do do business in that way, sure, but that doesn't change the ethics of those actions.

Re: The importance of honoring pro-rata agreements

#46

Post by joshu »

hglaser wrote: post #38
joshu wrote: post #17

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.

What do you say in those situations?

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.

Re: The importance of honoring pro-rata agreements

#47

Post by shalmanese »

austenallred wrote: post #2

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 p…

This has traditionally been the role of unions and why YC has morphed itself into a de-facto founders union to better negotiate terms like this across a collective of founders.

Re: The importance of honoring pro-rata agreements

#48

Post by btown »

chimeracoder wrote: post #15
tptacek wrote: post #10

Earlier quoted context omitted.

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.

> It's pretty straightforward, as ethical dilemmas go. "Excitement" comes nowhere close to justifying breaking your word. Agreed - this is inexcusable. If you lose an investment because a later-stage investor is keen on you cheating existing investors out of what you already promised them, I'd say you dodged a bullet - you don't want them owning any piece of your company. If your later-stage investors are so keen on…

And if your Series A investor denies pro-rata rights to your seed round investors, then it should expect to have its pro-rata rights denied in Series B. Which gives this Series A investor a perverse incentive to set up the company to look better in the short term to get it to Series B, rather than it acting in the IPO-timescale long-term interest of your company!
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