The Super Pro-Rata Signal

Here’s something I believe will become more prevalent as angel and seed funds which lead deals scale up and try to help their portfolio go to the next level: The increasing importance of a signal created by an existing investor who wants and/or takes a “super pro-rata” position in the next round of funding.

As a brief background, (1) a pro-rata right is sometimes granted to very early-stage investors as a reward (though not without controversy) to maintain their ownership position as a company matures and takes on more funding. This protects against dilution; and (2) many angel and seed rounds have quickly graduated from friends and families and credit card debt to taking funding from micro funds managing under $100M.

Back to the tip. My view is that as Series As continue to get harder to get done, and as more and more companies which have been funded are running out of runway, there will be another one to two huge waves of seed companies that just flop over — not even very light M&A, but rather droves being washed up ashore overnight. As this funnel tightens, and as there are too many companies for all Series A investors to properly track, I believe many of them will look for the super pro-rata signal in the majority of cases where the investment decision is not a unanimous, slam dunk term sheet.

If I’m on to something — and, fair warning, I could be wrong — one way a founder could leverage this dynamic is as follows:

1. As you’re gearing up for Series A, go meet your lead and/or larger seed investors in person. Give them a proper update. Tell them about the past, present, and future.
2. As the conversation evolves and hopefully goes well, invite them to not only take their pro-rata (most early-stage funds are set up with reserves to follow into a good portion of those who graduate to Series A), but ask them if they’ll take a super pro-rata position. This is an invitation for them to gain more ownership in your company.
3. Now, assuming those early larger or lead investor will be either the source of an introduction to the larger VCs and/or will certain act as an important reference, your investor can talk all day long about how great you are and how great your company is, but nothing will likely speak louder than if he or she simply writes something like: “Not only did we take our pro-rata in the company; we offered super pro-rata, uncapped into the next round, to demonstrate how much we believe in the company.”

For the larger VC who sees this, it sends a very sharp, strong signal. It cuts through the noise and pegs the earlier investor to put their money where their mouths are. In a world where early-stage investors make intros to VCs ten times a day, this kind of intro will definitely stick out as high-signal.

However, there are some risks to this approach, but I would argue they’re healthy risks: The lead or larger investors may politely say “no,” which may force the founder to examine why. Or, the early-stage investors typically don’t follow-on (as part of their model), so there’s no real way to leverage this dynamic. However, if this works, and if you’re earliest backers want to invest in more in you and you can use that as part of the “proof” of why a Series A round is deserved, I feel strongly that it will put the founder in a great position to have his/her pitch taken seriously. The larger VC will likely interpret the signal as a specific type of social proof and, assuming they respect the earlier investors’ work and judgment, it will make them feel a bit more at ease that other investors will also have a strong, vested interest in the company’s long-term arc.

Finally, as a post-script, I don’t want this post to smack of “gaming fundraising.” I think of this move as uncovering a hidden dynamic into today’s environment that rewards founders with hidden gem companies and those who communicate well and build trust over the long-term.