Pro Rata Right to Participate. Preemptive Right. Participation Right. Call it what you may but this is one of the most important economic rights that attach to the preferred security received by a seed investor when making an investment into a portfolio company. For early stage investors, particularly those funds with limitations on their ability to cut larger checks to put them in the running to lead future rounds, preserving the right to participate in a portfolio company’s follow-on financing is paramount to future returns. Here is a word of caution for you seed stage investors (and your lawyers): Don’t risk being shut out of your participation right by missing a simple, yet key, technical drafting feature in your deal documents. The following anecdote sheds light on how that could happen:
Recently I was representing a VC in a subsequent round of financing for one of their portfolio companies. The round was being led by a strategic investor that had not previously invested in the company. My client and certain other existing investors planned to exercise their right to participate in the deal pro rata through a subsequent closing but, as is standard in financings, at the initial closing, existing stockholders, including my client, agreed to waive their contractual right to participate pro rata in the round, with the understanding that they would participate nonetheless. Note to the reader: This waiver is almost always solicited by the company, regardless of whether the company and new investor intend to honor the right of existing stockholders to participate, as it removes the need for the company to comply with the hoops and notice periods set out under the existing preemptive rights provision and, by doing so, a company avoids further delay on closing the current financing. Existing investors end up getting comfortable consenting to the waiver so long as the handshake business deal allows them to participate for an amount at least as large as what they were contractually entitled to had they not waived.
So back to the deal I was working on….when the deal documents were distributed for final sign off, the lead investor had included language which would have subject participation in subsequent closings to that lead investor’s approval. Cue the lawyer’s alarm! With the participation waiver in hand at the initial closing and the lead investor’s ability to block who the company could accept as investors in subsequent closings, that set up a situation where existing investors could have technically been shut out of investing in the deal all together, in spite of the company’s desire to let them participate. Lesson for seed investors: ensure that your deal documents expressly carve out existing investors from lead investor’s block on who participates in subsequent closings, otherwise risk losing your ability to invest pro rata……and getting burned!