Preemptive Rights - Term Sheet Provision
What are Preemptive Rights?
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What is a Preemptive Right of First Offer?
Preemptive rights arise in the context of investment in startups as well as financing of larger corporations. In its most basic form, a preemptive right is an entitlement that allows specific shareholders (holders of preferred shares with preemptive rights attached) of a corporation the authority to buy extra shares in the company before the general public is able to purchase them.In a startup, this means existing investors can purchase shares in a follow-on round of funding before new investors are given the opportunity. The same rights applying a seasoned offering by a mature company.
Back to: LAW, RISK, and TRANSACTIONS
Preemptive rights relate closely with subscription rights, anti-dilution provisions, or preemption rights. These rights are put in a contract between the purchaser of the stock and the company (subscription/stock purchase agreement) or are contained in the articles of incorporation and bylaws.
Few states give preemptive rights as a matter of law unless the company's articles of incorporation specifically negate it.
When a majority shareholder of a firm or a shareholder investing large amounts of money to a startup company buys stock shares, he or she usually wants a guarantee that his or her ownership interest of power to vote as a shareholder cannot be diluted or abated by a secondary offering where the firm gives out a significant number of new shares with voting rights.
Securing preemptive rights when the initial stock is bought ensures that the shareholder can prevent any seasoned offering from diminishing his or her percentage of ownership.
With the preemptive right, the shareholder is granted an opportunity (but not obligation) to purchase a number of shares that is comparable to his or her current equity percentage of ownership before other investors are allowed to purchase shares. Therefore, it works as an option, but it is more like a first refusal right.
Take, for example, a company with an initial stock offering consisting of 100 shares and someone buys 10 of them. That individual has 10 percent equity interest in the organization. Down the line, the company issues a secondary or seasoned offering of 500 extra shares. If the first shareholder maintains a preemptive right, he or she has to be given the chance to buy 50 shares of the new offering to keep 10 percent interest in the company. If the shareholder declines to participate, the shares are available for purchase by other shareholders based upon their pro-rata share.
- Note: While anti-dilution provisions protect shareholders from loss of value in down rounds, this provision maintains the percentage of ownership. This is key, as the percentage of ownership directly affects return at the time of exit, voting rights, and protective provisions.
Preemptive rights are generally granted to preferred shareholders and may be limited in certain respects. Such limitations commonly include:
- Major Investor - Rights of first offer apply to holders of a certain amount or percentage of shares (Major Investors).
- Percentage Requirements - Basically, the pro-rata calculation is based upon the total number of preferred shares, rather than all common and common equivalent shares outstanding.
- Qualified Issuances - The preemptive rights do not kick in under certain circumstances. Generally, if the situation does not qualify as an issuance for purposes of anti-dilution protection, then it is not an issuance for purpose of preemptive rights.
- Beyond Pro-Rate Rights - The investor may request the right to purchase an amount of shares in excess of their pro-rate ownership percentage. This may include purchasing the pro-rate percentage of shareholders who do not participate in the follow-on financing round.
Back to: Entrepreneurship
What are Pay-to-Play Preemptive Rights?
A common provision is the pay-to-play provision, which incentivizes investors to take part in future rounds of financing of the startup. These provisions require that an investor invest in future equity rounds at an amount equivalent to their percentage of equity in the business (pro rata) to avoid dilution and potential loss of certain preferential rights.
For example, the pay-to-play provisions are often linked to anti-dilution protection. If an investor fails to participate in a dilutive financing on a pro-rata basis, then they forfeit their anti-dilution protection rights in the current financing round (and potentially any future financing rounds). This is effectuated by a conversion provision in the preferred shares that state that the shares will convert to an alternative class of shares (that only exists for this purpose) that contains all preferential provisions except the anti-dilution protections. This is a method of getting around state prohibitions on impairment of preferred shareholder rights. In some cases, failure to participate may forfeit any or all preferred rights by converting the shares to common stock.
The problem with this situation is that it causes all current investors to participate only at their current percentage and does not allow for a percentage to go to new investors. The method of addressing this is to allocate a specific number of new shares to existing shareholders and then require shareholders to purchase a pro-rate percentage of that block of shares. The company may provide that the pay-to-play provisions only apply to shareholders of a certain percentage of a class of preferred shares.
Back to: Business Transactions
What are Rights of First Refusal?
An alternative form of preemptive rights, known as rights of first refusal, regards sales by existing shareholders. Rights of first refusal are control mechanisms that generally grant the company the right of first refusal to purchase shares being offered for sale by an existing shareholder. For example, the business may hold the first right to purchase any shares sold by any shareholder, who can only sell the shares to an outside party if the business first refuses to purchase them.
The business (through the decisions of owners or directors) will retain the option of refusing to purchase the shares. If the business elects to purchase the shares, however, the shareholder is entitled to the price per share agreed upon by a disinterested, third party. Preemption rights are often accompanied by ancillary shareholder agreements that further limit the ability of investors to sell or otherwise transfer ownership in the company.
These provisions protect the existing business owners from a perceived risk of opportunistic behavior by other shareholders. While these provisions stand to affect both investor and entrepreneur, more commonly it protects the entrepreneur from an investor who wishes to exit the venture through the sale of her shares to unknown, and potentially undesirable, third parties.
What are Co-Sale Rights?
Co-Sale rights are control provisions that protect the investors interest by preventing founders from selling their equity interest and leaving the equity investor still holding their shares. Specifically, if a manager sells her shares, preferred shareholders have the right to participate in that sale in a pro-rata basis. While these provisions mitigate, rather than shift, risk among the parties, they demonstrate a general lack of trust in the intention of the entrepreneur with regard to the venture.
The Co-sale rights generally work in conjunction with rights of first refusal. If the rights of first refusal are not exercised by the company or by preferred shareholders and the manager sells the shares to a third party, then the preferred shareholders may participate in that sale. Investors will want all or large numbers of common shareholders to be subject to the rights of first refusal and co-sale rights. Founders, on the other hand, will want certain types of transfers (such as bequests and transfers to family) to be exempt from any right of first refusal or co-sale provisions.
Further, founders may want to limit the rights to preferred shareholders holding a minimum number of percentage of outstanding preferred shares. These provisions require that any seller of securities notify the board of an intended transfer to evaluate company and shareholder rights.