Changing policy, Y Combinator cuts its pro rata stake and makes investments case-by-case

Published April 16, 2020

In a message posted to its internal communications channel earlier this week, the massive startup accelerator Y Combinator said it will change the terms of its own PPP (the YC pro rata investment program) and investing in companies raising seed and Series A rounds on a case-by-case basis.

The company began a policy of investing in every seed and Series A round for its portfolio companies back in 2015.

Since then, it has taken a 7% stake in every company that raised a priced seed and Series A round, investing in more than 300 Y Combinator companies over nearly 500 rounds.

Under its new policy, the accelerator is reducing its investment size from 7% to 4% and is only investing on a case-by-case basis going forward.

The reason for the change is that the number of companies in its portfolio has gotten too large for it to invest and some of the limited partners who back the accelerator’s operations are balking at making commitments to the pro rata investment program.

“We have significantly exceeded the funds we raised for pro ratas, and the investors who support YC do not have the appetite to fund the pro rata program at the same scale,” the accelerator wrote in a post seen by TechCrunch. “In addition, processing hundreds of follow-on rounds per year has created significant operational complexities for YC that we did not anticipate. Said simply, investing in every round for every YC company requires more capital than we want to raise and manage. We always tell startups to stay small and manage their budgets carefully. In this instance, we failed to follow our own advice.”

For entrepreneurs who take investments from the accelerator, the change is pretty significant. On the accelerator’s internal messaging board they worried about the potential optics of having the accelerator not make a follow-on commitment.

YC addressed those concerns by saying it would not make an investment decision until a company had already received an initial term sheet from a lead investor.

The changes will take effect on May 8, 2020, the investor said.

“In the future, we will no longer invest automatically in every priced seed and Series A/B round. Instead, we will exercise pro rata rights on a case-by-case basis, like other investors on your cap table,” the accelerator wrote. “We’ve heard your feedback that YC’s pro rata allocation is bigger than what some of you would prefer. So for those investments we do make, we will reduce the size of our pro rata and simplify its calculation to be a flat 4% participation right in each priced round. To calculate the size of YC’s pro rata investment in your round, simply multiply the amount of capital you are raising by 4%. If our ownership right before the round is less than 4%, we will cap our investment in the round at our then-current ownership. Our intention is not to have a super pro-rata right.”

Even with the reduced investment size, YC said it would only make investments in roughly one-third of its portfolio.

“The YC Continuity team will manage these investment decisions and will work very hard to inform you within a day or two of receiving your materials,” the accelerator wrote. “We will honor any pending pro rata investments for term sheets signed before May 8. But we wanted to communicate this message broadly so that founders can plan accordingly.”

What founders need to know about pro rata rights

Published August 1, 2019

Andy Sparks
Contributor

Andy Sparks is the co-founder and CEO of Holloway, a publishing and technology company that creates comprehensive, practical guides researched, written, and refined by experts.

In the context of a term sheet, pro rata rights (or pro rata) govern whether investors may continue to invest in subsequent rounds of funding in proportion with their ownership. Investors with pro rata rights can invest in the company’s next round an amount that will allow them to maintain their ownership percentage.

This is an excerpt from the Holloway Guide to Raising Venture Capital, a comprehensive resource for founders of early-stage startups, covering technical details, practical knowledge, real-world scenarios, and pitfalls to avoid. Read our accompanying article about the company over on TechCrunch.

Pro rata is Latin for “in proportion.” Most people are familiar with the concept of prorating from dealing with landlords: if you’re entering into a lease halfway through the month, your rent may be prorated, where you pay an amount of the rent that is in proportion to your time actually occupying the property.

Almost all investors try to negotiate for pro rata rights, because if a company is doing well they want to own as much of it as possible. After all, why not double down on a winner than use that same money to invest in a newer, unproven company? In the 2018–2019 fundraising climate, though, it’s safe to say we’re at “peak pro rata.” Everybody wants pro rata, even those who don’t entirely understand how it works or affects companies.

Some founders include a major investor clause in the term sheet, which reserves certain rights and privileges to those they deem “major investors,” based on amount invested or number of shares purchased. Whether to grant pro rata rights to all investors or only those above a major investor threshold is a tricky decision for two reasons.