A participation right is the right of existing investors to participate in future rounds of financing. Sometimes referred to as a pro rata right, this participation right may show up in the seed round and is usually limited to major purchasers. The participation right gives the current set of investors the right to purchase their pro-rata share of any new stock being sold by your company. The participation right gives investors the right to keep their same percentage of equity as the company raises future rounds. The reason why it is limited to major purchasers is because this right can become burdensome as the investor base grows. Very often, a seed round may include a large group of minor investors such as family and friends. The legal fees for calculating the pro rata rights for minor investors can be more expensive than the investment’s worth. Thus, the participation right is limited to major purchasers in the Series Seed term sheet.
The pro rata participation rights is important to investors because it helps them protect their ownership percentage in the startup. A participation right ensures the investor is able to participate in a subsequent round on a pro rata basis. This means that for as long as the investor continues to invest, his or her ownership of the startup will not be diluted.
From an entrepreneurial perspective, the participation right is a neutral concept because founders usually welcome investment. Furthermore, it is always positive for the startup to signal that prior investors are participating in future rounds. However, this is usually a right that the current set of investors want but the incoming investors dislike (or prefer the right to be somehow limited). This is because the participation right will affect the ownership percentage the incoming investor could purchase while existing investors want to ensure their ownership percentage would not be reduced. As your investor base grows, the participation rights could cause tension between investors from different series.
The participation right gives the current set of investors the right to participate in future rounds on the same terms offered to the subsequent round of investors. Pro rata participation right does not guarantee that the investor’s shareholding will not be reduced, it simply offers the investor an opportunity to participate in the subsequent round of financing.
For example, an investor invests $500K in a seed round and owns 25% of the startup. The next round is a $1 million round ($2 million pre money valuation and $3 million post money valuation). The investor is given the right to participate and buy 25% of the round (i.e.,$250K), so the investor can continue to own 25% of the startup. Otherwise, the investor will be diluted and own around 17% of the startup. Therefore, the pro rata participation right does not guarantee the investor always owns 25% of the startup. You can see how administratively burdensome it could be to calculate the pro rata participation rights of everyone in a large group of minor investors and to obtain their response on whether to participate.
In the Series Seed term sheet, the participation right is as follows:
Participation Rights: Major purchasers will have the right to participate on a pro rata basis in subsequent issuances of equity securities.
Thus, major purchasers have the right to purchase enough shares in the next round of financing to ensure that they maintain their current equity ownership percentage.
Read the whole Founder’s guide to SEED funding here.