Today's topic: how to think about pro-rata rights

Today is the 81st edition of Small Bets. Since we launched this newsletter, we've dug into a number of hairy investment terms (examples: uncapped notes, follow-on checks, SPVs, market pull). There's another term I'd love to dissect today: pro-rata rights.

Pro-rata rights give an investor the opportunity to maintain her/his ownership percentage when a company raises later rounds of capital. Basically – it promises early investors the chance to invest more money into a startup in future fundraising rounds. A lot of investors out there – VCs in particular – are quick to execute their pro-rata rights when a portfolio companies raises subsequent rounds.

But this may not be the best move. Let's discuss.

Going back to first principles

Let's remember why we invest in the first place: to make money. Yes, there are a number of other, less capitalistic reasons that drive people to invest. Maybe we're passionate about solving a particular problem, or about supporting a particular group of founders.

But if that were the only motivation, we would donate all our money to charity. A big part of why we invest is to see a return on our investment. Now, angel investors could see pretty much any return on their investment and it would be a win. But VCs have their own investors to think about. The mathematics of running a fund are complicated (like, really complicated) but suffice to say that a VC is looking for a startup to provide a 100x return.

This enables a VC to cover the losses of their other portfolio companies, pay administrative fees, and take home profit themselves.... all while returning money to their LPs.

Getting a 100x multiple

Let's say you invested $100k into a startup at a $5m post-money valuation. To get a 100x multiple on this investment, the company needs to exit for at least $500m. Then the company raises another round and invites you to execute your pro-rata rights. If the company is doing well, you may be tempted to plop down the additional funds to keep your ownership percentage.

But hold up – the company isn't a pre-seed startup anymore. They've de-risked the business (at least a little). So the valuation has gone up. It's not absurd to think that the valuation is now $20m or more.

If you want to keep your 20% ownership, you'd need to invest an additional $400k into the company. And then the company would need to exit for at $2.5B for you to see a 100x return on your investment (assuming no dilution for easy math).

When to execute pro-rata rights

Whether or not you execute your pro-rata rights will depend a lot on the company and the terms of the deal. Maybe the company is doing super well but is having trouble raising. Maybe this means the valuation is lower than other companies with similar growth metrics. Maybe you have insider information about why the company is de-risked. These could all indicate that a follow-on check makes sense.

But if the company is doing super well and lots of investors are interested, then the valuation may be insanely high. If this happens, it may make sense to allocate that $400k elsewhere. For example... you could invest $100k into 4 new companies with much lower valuations and aim for 100x multiples with each of those bets.

Investing is a comparison game

In an ideal world, you'd be able to re-invest in your existing portfolio companies and take bets on new companies as well. But you have a finite amount of capital to invest. So making an investment isn't just a question of "is this a smart bet to make?". It's a question of "is this the best use of my $400k?". And to answer that question, you need to weigh your options against each other.

Option 1: double-down on a startup that may or may not have found true product/market fit... that may or may not have found a path toward a 100x exit... and that has a higher valuation than when you first invested.

Option 2: invest smaller amounts into several new companies... that haven't been de-risked yet... but that offer lower valuations and therefore require a smaller exit to get to 100x return.

There isn't a right or wrong answer. And it'll probably be years before you know whether you made the right call.