It’s a bold but true assertion: pro rata participation rights (otherwise known as pro rata rights) are a venture capital investor’s one true superpower.
A good analogy is the game of blackjack or Texas Hold ’em. Besides luck, the skilled way to win the game against the house or opponents is to double down on winning hands. In effect, the player can capitalize on knowledge and odds they did not have before. Only inexperienced blackjack players do not use this knowledge and act on it.
The same is true in venture and growth-stage investing: the best way to improve the odds of winning is to leverage information that one did not have in the early rounds – then double down on winning investments. The best VCs recognize this strategy and defend their pro rata rights to the hilt. They know it’s the key to remaining top-quartile investors. It is one of the reasons why venture capital is one of the few asset classes where there is persistent return over generations among the top-quartile VCs. They don’t give up their pro rata rights. You will not see Sequoia, Insight, Accel or Bessemer back down when they have a great hand.
Given the power law, where 90 percent of all capital returned comes from less than 10 percent of invested capital, it’s logical that portfolio construction is critical. It is the difference between a mediocre fund and a top-decile performer, between losing money in the asset class (<0 percent>
Let’s take on the issue of portfolio construction first. On the latest episode of our Driving Alpha podcast, the legendary angel investor Jason Calacanis (of Launch Fund and the All-In Podcast) discusses his evolved approach to portfolio construction. He says that among 109 pre-seed stage investments for a previous fund, four became “unicorns” exceeding one billion dollars in valuation. Historically, Jason’s fund had never executed follow-on investments, but after doing the math, he came to an eye-popping realization: just one follow-on investment in one of his four unicorns would have taken the fund’s return from 5x (which is admirable considering that 2-3x is top quartile) to an astonishing 15x.
Following on to winners also matters for GPs and LPs. This is more pressing since the average time to exit in venture has grown from four to six years in 1994 to 10 to 12 years today. When Yahoo and Amazon went public, they had only raised a B round. And eBay had only raised an A round by the time it went public. Today, the vast majority of VC-backed companies raise a C, D, E and sometimes an F, G or H round and beyond – diluting VCs and LPs if they don’t participate in their most lucrative follow-on investments.
If a fund can increase its return multiple from 5x to 15x by following on in its best companies, why don’t more VCs do it?
Indeed, early-stage VCs with less than $100 million under management are among the first funders of 80 percent of unicorns and companies that IPO. Yet, most of the time they do not follow on in their full pro rata rights past Series A. This is due to several factors:
- First, a lack of capital reserves five-plus years after the initial investment
- Second, efforts to save dry powder for less successful companies that might become unicorns
- Third, the effort to have as many ‘shots on goal’ to have more unicorns in the portfolio
- Fourth, an aversion to diluting potential on-paper returns
- Fifth, the lack of expertise in evaluating growth rounds
- Sixth, lack of time. The list goes on…
One way a VC may exercise its pro rata rights is by raising fresh capital through a special purpose vehicle (SPV). But they rarely pursue that route: Pitchbook reports that early-stage VCs attempt to raise SPVs from existing or new LPs less than 5 percent of the time. One of the challenges VCs face is that savvy LPs in emerging managers often negotiate no fee/no carry for co-investments. Another complication is that traditional fund LPs and non-LPs are often slow to respond to direct deals where they lack expertise.
This is complicated by the fact that a VC is conflicted when it offers a co-investment to its LPs, as the VC is supporting a prior investment it made. This is similar to the reason why LPs do not like firms that cross invest from different funds. Oftentimes these days, LPs are capital constrained. Finally, VCs cannot broadly market their pro rata opportunities because it is risky for a VC to share their best company’s confidential information with untrusted third-party outsiders.
Based on our periodic reviews of current and historical data, we estimate that up to 98 percent of pro rata rights go unused by early-stage VCs, amounting to a $50 billion to $100 billion unused pro rata market opportunity. And unlike early-stage investments, from what we understand from our friends at Cambridge Associates, investing at Series C earns a return 85 percent of the time, sometimes as much as another 10-20x.
In support of early-stage VCs, Alpha Partners began to solve this pro rata gap in 2014. Our model is to be an on-demand pro rata capital source for the best deals coming from constrained early-stage VCs. We share the profit interest with them to help them generate better returns for themselves and their LPs.
The second investment we made, in a round led by Sequoia, yielded more than $40 million in shared carried interest profit for the source VC that Alpha facilitated for the transaction. That VC had less than $5 million in AUM at the time, so this was a remarkable instance of a small fund monetizing its pro rata rights.
For the early-stage VCs and their LPs, there’s more upside than just economics. Often, maintaining their position as a major investor in a company can keep them on the board as well as retain their precious information rights. Staying close to founding teams is the number one way that early-stage VCs source their best early-stage investments as well as recognizing new trends as they emerge. By retaining their pro rata rights beyond Series C, they more likely will be able to support the company and also capture additional downstream investments that grow increasingly de-risked through an IPO.
The bottom line is this: early-stage investors’ pro rata rights are a superpower. VCs should ensure those rights are in place and exercise them in follow-on rounds, even if they’re venturing into unfamiliar territory. VCs should consult with their legal counsel, as necessary, and defend their pro rata rights to the hilt. If they don’t, those rights are unlikely to be around for the next cycle. On their best deals, Sequoia, Insight, Accel and Lightspeed do not give up their pro rata rights. Neither should smaller VCs and the LPs that back them.
Steve Brotman is the founder and managing partner of Alpha Partners, a growth-equity firm that co-invests in venture-backed companies by leveraging the unused pro-rata rights of more than 1,000 early-stage VC partners. He can be reached at steve.vc@alphapartners.com