Understanding the Power of Pro Rata Rights in Venture Capital
Steve Brotman, Managing Partner at Alpha Partners, was published in the Venture Capital Journal. The article sheds light on an often-overlooked aspect of venture capital investing: pro rata rights. Titled “Pro Rata Rights: The Overlooked Superpower of VCs and their LPs,” Brotman’s piece delves into the critical role these rights play in driving top-tier returns for venture capitalists and their limited partners (LPs).
Pro rata rights, or the right of investors to maintain their ownership percentage in subsequent funding rounds, are likened by Brotman to doubling down in blackjack or Texas Hold’em. Just as a skilled player leverages newfound knowledge to capitalize on winning hands, VCs can enhance their portfolio performance by doubling down on successful investments in later stages.
Brotman emphasizes that the best VCs vigorously defend their pro rata rights. This strategy is crucial for staying in the top quartile of performers. The persistence of returns among top VCs across generations is largely attributed to their steadfast use of pro rata rights. Notable firms like Sequoia, Insight, Accel, and Bessemer are highlighted as examples of VCs who consistently leverage this strategy to remain industry leaders.
Portfolio Construction and the Power Law
The power law in venture capital, where a small percentage of investments yield the majority of returns, underscores the importance of strategic portfolio construction. Brotman cites Jason Calacanis, a legendary angel investor, who noted that his fund’s return could have jumped from 5x to 15x with just one follow-on investment in a unicorn. This illustrates the transformative potential of pro rata rights.
However, many early-stage VCs fail to utilize their pro rata rights beyond Series A due to several reasons, such as a lack of capital reserves, the desire to maintain flexibility for other investments, and challenges in evaluating growth rounds. These factors contribute to a significant underutilization of pro rata rights, which Brotman estimates leaves a $50-100 billion market opportunity untapped.
Alpha Partners’ Solution
Maintaining pro rata rights extends beyond financial returns. It allows early-stage VCs to remain on company boards and retain information rights, which are vital for sourcing future investments and staying attuned to emerging trends. Brotman’s bottom line is clear: Early-stage investors must ensure their pro rata rights are in place and exercise them diligently. This approach is not just a strategic advantage but a necessity for long-term success.
Alpha Partners addresses this gap by providing on-demand pro rata capital for the best deals from constrained early-stage VCs. By sharing profit interests, Alpha Partners helps these VCs and their LPs generate better returns. Brotman shares a notable success story where a small VC fund monetized its pro rata rights, resulting in a significant profit.
For VCs and LPs alike, understanding and leveraging pro rata rights can be the key to transforming good returns into extraordinary ones.
