#Common stock pro rata pro#

#Common stock pro rata pro#

Pro rata rights are often used to protect the interests of early investors, and to prevent the dilution caused by later rounds. In the event of dilution the investors pro rata rights are triggered, meaning they have the ability to purchase additional shares from the new allocation to maintain their ownership percentage. This can happen in a number of ways, such as when a company raises money through a round of equity financing, or when they issue a new options pool to employees.

Dilution occurs when a company issues new shares of stock, which reduces the ownership percentage of each existing shareholder. The concept of dilution plays a key role in understanding pro rata rights. One important note is that the investor needs to put in additional capital in future rounds to maintain their equity percentage-if they choose not to invest, they get diluted. In general, there are five different types of preferred stock: cumulative preferred, non-cumulative, participating, convertible, and callable.Pro rata rights (also known as “participating rights”) are a contractual provision that give investors the right to maintain their percentage ownership (and their voting power) even when new shares are issued in future equity raises. Preferred shareholders always receive their dividends first and, in the event the company goes bankrupt, preferred shareholders are paid off before the holders of common stock. The main benefit of owning preferred stock is that the investor has a greater claim on the company's assets than common stockholders. Participating shares give a VC the best potential upside as they can freely choose from liquidation or an optional conversion. A VC will agree to a higher valuation if it is accompanied by a participating preferred security-essentially challenging the company to earn the upside of the higher valuation. Participating preferred is often used as a 'bridge' between a company that desires a higher valuation and a VC that believes in a lower valuation. In Q2 2017, 69% of financings had no cap on participation. This means after liquidation, holders of participating preferred shares can have a payout up to a certain multiplier of their initial purchase price. When participating, entrepreneurs have the option to set a cap on participation. In the second quarter of 2017, financings that provided participation made up only 13% down from 25% in Q3 2015. Participation in liquidations in venture capital fundraising has slowly come out of trend. If the dividend is not cumulative, preferred shares are not paid a dividend until the board of directors approves of a dividend. If the company is unable to pay this dividend, the preferred shareholders may have the right to force a liquidation of the company. Thus, the company must pay all unpaid preferred dividends accumulated during previous periods before it can pay dividends to common shareholders. Also, unlike common stock, a preferred stock pays a fixed dividend that does not fluctuate. Preferred stock shareholders may or may not enjoy any of the voting rights of those holding common stock. Like common stock, preferred stocks represent partial ownership in a company. The remaining proceeds are distributed based on ownership. Pro rata means as a function of number of common shares on an as converted basis. In a liquidation, participating shares distribute the remaining assets with common stock pro rata. Holders of participating preferred stock will always pick the option with the highest payoff. In an optional conversion, all shares are converted into common stock. In a liquidation, they first get their money back at the original purchase price, the balance of any proceeds is then shared between common and participating preferred stock as though all convertible stock was converted.

Holders of participating preferred stock have the choice between two payoffs: a liquidation preference or an optional conversion.

This form of financing is used by private equity investors and venture capital (VC) firms. Participating preferred stock is preferred stock that provides a specific dividend that is paid before any dividends are paid to common stock holders, and that takes precedence over common stock in the event of a liquidation. Non-Participating Preferred Illustration.