Lee Edwards, a partner at Root VC, says the firm “earns proportional rights, not gives.” That may be a bit of an exaggeration, since it refers to the term VCs write in their term sheets: proportional rights, which give VCs the right to buy more shares in a portfolio company in subsequent funding rounds, thereby maintaining their ownership percentage and avoiding dilution.
Still, these rights are not exactly “earned” but can be expensive. One of the newest trends in VC investing these days is funds dedicated to helping seed VCs exercise their pro rata rights.
The problem is that in later rounds, the new lead investor usually gets the preferred allocation, while other new investors try to get as much as possible, but existing investors have to pay the amount the lead agreed to pay per share in order to exercise their proportional rights.
And often, new investors prefer to take proportional investors out of the round entirely and take more for themselves, while founders want to limit the total amount of company they are willing to sell in the round.
“It’s common for downstream investors to want to take as much of the round as they want, and sometimes they’ll tell the founder that they need a large enough allocation that they don’t have room for pro rata rights. That means asking the founder if they’re willing to give up pro rata rights to the previous investors,” Edwards told TechCrunch.
Early investors often had to rely on founders to “fight for us and say no to our calls,” he said, and that only happened if they provided enough value for investors to feel comfortable negotiating on their behalf.
Securing capital to participate in the game
Sometimes venture capitalists choose not to exercise their proportional rights. They may forgo buying more shares in a struggling startup, but they often have to forgo buying more winners because they can't afford it.
For example, between 2020 and 2022, during the VC investment frenzy, Edwards saw many early-stage funds underperform later-stage rounds due to what he called “flashy valuations.”
In fact, later round new investors often run larger funds and can afford to pay more per share than seed investors, making it difficult for early investors and smaller funds to continue participating in later rounds.
This is where investment firms like Alpha Partners, SignalRank, and SaaS Ventures come in. All three support seed and Series A VCs who want to deploy capital at the Series B level and beyond, exercising proportional rights.
“For example, when Sequoia invests in a Series A, other existing investors can participate,” SaaS Ventures partner Jesse Bloom told TechCrunch. “But to participate in a Series B, you either have to be invited by Sequoia or the founders, or you have to participate in the Series A. My job is to hear about it in my network, find the Series A investors, and offer them a pro rata stake. I give them the pro rata stake, and I take 10% of my equity.”
Most, if not all, of the names on Bloom's list of top VC firms monitoring late-stage deals are familiar names, from Andreessen Horowitz to Insight Partners to Valor Equity Partners.
He also said that if a top VC fund leads the deal, it can be decided quickly because there is no need to do a lot of due diligence. “That’s the only way I can get in. I’m betting on the unfair advantage of the top guys.”
Bloom said that’s another reason he only invests in deals led by the top 25 VC funds listed on his website. “We believe that in later-stage venture capital, access is more important than due diligence over the long term, and we will do whatever it takes to get access to deals led by top funds, even if it means not knowing much about the company,” he said.
Bloom worked at Alpha Partners before being hired by SaaS Ventures leaders Colin Gutman, Brian Geister, and Seth Schuldiner to raise a fund to compete with Alpha.
He has now closed a new fund for SaaS Ventures, with $24 million in capital commitments to invest in scalable opportunities. The new fund’s limited partnership is anchored by Pennington Partners, which manages several family offices. It is also supported by a registered investment adviser who understands the benefits of large venture capital firms but cannot invest at higher ticket sizes, Bloom said.
Bloom has already closed five deals, including Apollo.io’s Series D and MaintainX’s Series C led by Bain Capital Ventures, Cover Genius’ Series E led by Spark Capital, and Elisity’s Series B round led by Insight Partners.
Proportional boom
Bloom isn’t the only one to have found success with a proportional target fund. Keith Teare’s SignalRank is chasing a $33 million fund that started raising in January, according to SEC filings. Alpha is also raising a new fund that targets proportional targets, according to Steve Brotman, managing partner at Alpha Partners. The firm has secured a little over $125 million in capital commitments, and he expects to close on more than $150 million by the end of July.
Bloom said that since many of the early investors who came to the company’s capital table wrote checks of $1 million to $3 million, pro rata was traditionally the only way to get into these large deals. Even for founders, these types of deals support existing investors.
“We are essentially an LP for existing investors, so they can have a proportional right to anti-dilution,” he said. “At some point, the founders are going to cut out the existing investors, so I’m giving them access to very cheap, fast capital.”
As Edwards of Root VC noted, investors weren’t rushing to do proportional deals two years ago. Today, things look different. According to Bloom and Brotman, proportional games are heating up, and that’s largely because there are fewer deals happening in the later stages, making it harder to get access to larger deals.
According to the PitchBook-NVCA Venture Monitor, VCs raised $9.3 billion in capital across 100 U.S. funds in the first quarter of 2024, representing just 11.3% of the $81.8 billion raised in the market in 2023.
Investors say this leaves an unusually large number of VCs unable to fund pro rata rights. In fact, Brotman says 95% of the time, investors don’t do pro rata rights.
“Pro rata rights and opportunity funds really exploded in 2021 and 2022, and then started to decline in 2023,” he told TechCrunch. “There are very few funds raising money in 2024 from smaller funds. LPs are figuring this out. They did a lot of co-investments in 2022 and 2021, and frankly, they hurt their butts because they invested too quickly at huge valuations.”
He likened it to playing the card game blackjack, where you can double your bet based on what the dealer is showing if you have a certain hand. “If you don’t double when you can, the casino wins. That’s the same thing in venture capital, but no one talks about it,” he told TechCrunch.
Renowned angel investor Jason Calacanis, founder and CEO of Inside.com and Launch, told Brotman in May on his podcast “Driving Alpha” that if he had used pro rata follow-on rights in his first fund, he could have tripled his returns. He’s already five times as good. So why didn’t he?
“Well, back then, you were trying to use 100 swings, or in this case $10 million, 109 swings, to hit one outlier according to the Power Law,” Calacanis said. In this case, the “Power Law” is when a single investment generates a greater return than all your other investments combined.
Among institutions and family offices, risk and timeframe are now in play, with timeframe being the “real killer,” Brotman said. Many of these institutions have three to six years to prove their worth, rather than 10 to 15 years, he said.
Venture capitalists should pay more attention to winners and talk to founders about why it’s important to do so. Also, if they can exercise proportional rights, they can often stay on the board, which is important for early-stage VCs, Brotman said.
“A critical component of being a venture capitalist is the ability to ride unicorns,” he said. “Even if they’re not on the board, the fact that they’re investing, the CEO is still going to spend more time with them and answer their calls.”
