Preemptive Rights: What are they?

Preemptive rights (also referred to as preemption rights, anti-dilution rights, subscription rights, or subscription privileges) are rights granted to certain equity holders giving them the option to purchase additional shares of a company’s stock or other securities before new investors can buy them. Preemptive rights are used to prevent new investors from reducing ("diluting") the ownership percentages of existing share or securities holders.

Preemptive rights are a common provision found in company shareholders’ and operating agreements, as well as other option, securities and merger agreements. They may also be included in the text of the subscription agreement that investors sign when purchasing stock or securities.

In addition, preemptive rights are often granted in connection with convertible preferred shares, enabling preferred shareholders to maintain their future ownership percentages when exercising options to convert their preferred shares to common shares.

Most states only consider preemptive rights valid if they are explicitly stated in a corporation’s charter. Additionally, corporation laws in some states require that preemptive rights be automatically given to shareholders of corporations formed in those states, unless specifically excluded in the corporation’s articles of incorporation.

Preemptive rights should not be confused with ”put options”, which give shareholders the right to sell the stock at a specified price.

Why are Preemptive Rights important?

A start-up company will typically seek funding in stages (“rounds”). Investors investing money in the early stages typically demand the right (not the obligation) to maintain their ownership percentage in the company when money is raised in later rounds. This right is ensured with the granting of preemptive rights.

Without preemptive rights, the shares owned by early investors become “diluted” (i.e., the ownership percentage of early investors decreases) as new shares are issued to later investors. Here’s an illustration:

  • Your company’s initial round of equity consists of the sale of 200 shares of common stock.

  • An investor purchases 20 shares in the initial round, giving her a 10 percent ownership interest in the company. Along with the purchase, the investor is granted a preemptive right to purchase subsequent shares in order to maintain her 10 percent ownership in the company.

  • In the second round of equity, the company offers for sale an additional 1,000 shares of common stock.

With the preemptive right, the investor may purchase up to 100 shares of the newly offered 1000 shares in order to maintain her 10 percent ownership in the company. Without the preemptive right, her interest in the company will be diluted (that is, her ownership percentage will decrease) to 1.67 percent, if the entire 1,000 second round shares are sold.

Reasons to Consider Granting Preemptive Rights:

Here are a few of the reasons you should consider granting preemptive rights to your investors:

  • Early stage, angel, and venture capital investors typically expect, and often demand, preemptive rights as part of their investment agreements. By granting such rights to investors, it will typically be much easier and faster for your company to raise money from investors in later funding rounds. Investors with preemptive rights are already familiar with your company and are essentially “locked in” to their investment positions.

  • Potential new investors can cause time delays while performing due diligence on your company and during investment negotiations. Early investors with preemptive rights are likely to supply additional funding in later equity rounds. That means locating new investors will require less time and effort on your part, allowing you and your management team to concentrate on what is most important: operating your business.

  • A major investor with a large ownership percentage in your company will likely demand the right to appoint one or more members of his choice to the company’s board of directors, and/or to a vote on important company decisions. Therefore, the option to maintain a high ownership percentage, through preemptive rights, provides a strong incentive to early investors to participate in later equity rounds.

  • Some preemptive rights provisions include what is known as a “pay to play” requirement. Pay to play features provide for penalties (such as the conversion of preferred stock to common stock at the pre-issuance conversion price) to investors who choose not to exercise their preemptive rights in subsequent equity rounds.

Reasons to Consider Not Granting Preemptive Rights:

The following are a few reasons to consider not granting preemptive rights:

  • By opting to not grant preemptive rights, your company will have more flexibility in locating new investors and negotiating investment terms with them on an individual basis.

  • Investors who accumulate a significant stake in your company are likely to demand additional rights and greater involvement in the company’s management. By denying preemptive rights, you may be able to maintain management control of your company by limiting size of an individual investor’s company ownership percentage.

  • Preemptive rights can create an unwanted administrative burden when you are trying to raise new money. For example, it becomes more difficult to promise a new investor that she will be able to acquire a certain percentage of the company if you are uncertain as to whether or not early investors intend to exercise their preemptive rights.

  • Existing shareholders with preemptive rights are likely to demand detailed information from the company regarding subsequent equity rounds in order to decide whether or not to exercise their preemptive rights. This will likely result in unwanted time delays in raising additional funds. One possible solution to this problem is to grant preemptive rights only to your significant shareholders/equity holders (i.e., those owning more than a threshold percentage of your company’s equity).

Common Mistakes Associated with Preemptive Rights

Companies should bear in mind that certain issuances of new securities should be exempted from preemptive rights. Examples of customary exemptions include:

  • Shareholders converting preferred stock to common stock under the existing terms of preferred stock ownership.

  • Shares of stock or equity units awarded to valued employees as part of their compensation.

  • Shares of stock or equity units designated in employee equity plans.

  • Stock shares or equity units associated with company restructuring, such as an equity split (increasing the number of authorized shares/units) or equity combination (reducing the number of authorized shares/units).

Frequently Asked Questions

  • Are preemptive rights the same as anti-dilution rights?

Preemptive rights are a type of anti-dilution right designed to maintain an equity holder's percentage ownership in the company.

Preemptive rights should not be confused with other anti-dilution rights designed to maintain the value of an equity holder's original investment during later equity rounds involving a lower company valuation and lower price per share/unit than paid by the earlier investors (a “down round”). In the case of a down round, earlier investors typically have a right to receive additional shares or units based upon a formula contained in the company’s shareholders’ agreement or operating agreement.

  • If a company grants preemptive rights, are all equity holders required to get them?

Not necessarily. However, under corporation laws, all shareholders of the same class must be treated equally in regard to preemptive rights.

Additionally, a corporation with multiple classes of stock may provide preemptive rights for some classes and not for others. This is particularly true for an LLC, whose more flexible legal structure makes it easier to grant preemptive rights to some members than to others.

  • Can an equity holder increase his pro rata percentage ownership of a company in a later round of equity through the exercise of preemptive rights?

Yes. Preemptive rights are sometimes structured to allow shares or equity units not purchased by an investor in an early equity round to be purchased by other early investors in subsequent equity rounds. As a result, an equity holder may be able to increase his pro rata percentage ownership in the company.

Support for Preemptive Rights

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