Preemptive rights grants existing investors the right to purchase any new shares that may be issued by the company at the same price per share as existing shareholders.ย 

ย 

Preemptive rights are a form ofย anti-dilution protection, and they ensure that early investors’ ownership stake in a company is not diluted by the issuance of new shares.

ย 

What are preemptive rights?

Preemptive rights give existing shareholders the right to purchase additional shares before those shares are issued to other investors or buyers – usually referred to as โ€œpre-emptingโ€ these further issuances.ย 

ย 

In such cases, early investors will be given an opportunity to invest in any new equity financing rounds at the same terms and conditions as outside investors. This means that they will be able to retain their same proportionate ownership interest in the company and protect themselves against dilution due to equity financings.

ย 

A contract clause may offer one of two preemptive rights: the ratchet based provision or the weighted average provision.ย 

ย 

The ratchet provision allows a shareholder to convert preferred shares to new shares at the lowest sales price of the new issue. The weighted average allows current shareholders to buy additional shares at a price that is adjusted for the difference between the price paid for the original shares and the price of the new shares.

ย 

ย 

Need to level up your VC skills? We’ve got you covered.

Confluence.VC Resource Library

ย 

ย 

ย 

What is the purpose of preemptive rights?

The purpose of preemptive rights is primarily to protect the interests of early investors from dilution, but it can also serve as an incentive for investors who have been loyal and have invested their money early on in the life of a company.ย 

ย 

Preemptive rights allow them to participate in future funding rounds along with newer investors, thus keeping their ownership stake relatively higher than it would otherwise have been. This also helps incentivize long-term investments and encourages loyalty among investors who have already shown faith in a particular business venture.

ย 

Preemptive rights are often, but not always, included as part of a Stock Purchase Agreement (SPA) between a company and its investors, or found explicitly stated within corporate charters or articles of incorporation.

ย 

Why are preemptive rights important?

Preemptive rights are important because they protect current shareholders from having their ownership percentage diluted with additional rounds of funding.ย This matters especially for investors that take a targeted approach to investing and prioritize their equity ownership in each companies.

ย 

Additionally, preemptive rights incentivize long-term investments and loyalty among investors who have already shown faith in a particular business venture by allowing them to maintain their proportionate ownership interest in the company.

ย 

Preemptive rights reward investors who have been loyal and invested early on in a company’s life cycle.

ย 

Reasons to consider granting preemptive rights

Reasons to consider granting preemptive rights include protecting the interests of current shareholders from dilution, incentivizing long-term investments and loyalty among investors who have already shown faith in a company’s venture, and providing an incentive for investors who have been loyal and invested early on in the company’s life cycle.

ย 

Preemptive rights can also ensure that new shares are issued at the same price per share as early investors so they do not suffer financial losses due to lower share prices or dilution of ownership.

ย 

Additionally, preemptive rights help prevent potential hostile takeover attempts by outside investors or buyers.

ย 

ย 

Does all stock have preemptive rights?

No, not all stock has preemptive rights.

ย 

Preemptive rights are generally granted to preferred shareholders of a company through the Stock Purchase Agreement (SPA) or explicitly stated within corporate charters or articles of incorporation.

ย 

ย 

How are preemptive rights calculated?

Preemptive rights are calculated by determining the proportionate ownership interest of existing shareholders in a company. This proportion is then used to calculate the number of new shares that each shareholder will be issued in a future equity financing.

ย 

For example, if an investor owns a certain percentage of a company, they would be entitled to receive that same certain percentage of any new shares offered in a future financing round. This ensures that the investor’s current percentage ownership in the company stays relatively constant. Majority owners could maintain their majority by exercising the preemptive rights they were granted.

ย 

This calculation is generally done according to either an investor’s proportionate ownership in terms of a percentage of the total number of shares outstanding or in terms of a percentage of the total voting rights.

ย 

Preemptive rights can also be subject to additional limitations, such as a cap on how many shares each investor can purchase. This is typically done to ensure that the company does not become too concentrated in the hands of one or two investors.

ย 

Can you sell preemptive rights?

Yes, preemptive rights can be sold.

ย 

Preemptive rights are a type of contractual right that allow existing shareholders to purchase new shares issued by a company at the same price as existing shareholders.

ย 

These rights can be sold to third parties, allowing investors and entrepreneurs to capitalize on their preemptive rights. By selling the right to purchase new shares before they are issued, investors can benefit from the upside potential of an equity financing while also taking advantage of the liquidity provided by the market.

ย 

However, it is important to note that preemptive rights can be difficult to value and are subject to additional restrictions, such as a cap on the number of shares that can be purchased.

ย 

Can a preemptive right be denied?

Yes, preemptive rights can be denied.

ย 

Companies may choose to withhold preemptive rights from certain investors, or they may impose additional restrictions on the exercise of such rights. Examples of these restrictions include a limit on the number of shares that can be purchased by an investor or a requirement that an investor holds their stock for a certain length of time before being able to purchase new shares.

ย 

Additionally, companies may not offer preemptive rights at all in certain situations, such as when there is no expected need for immediate capitalization during future equity financings. Ultimately, it is up to the company’s board of directors and shareholders to decide if and how preemptive rights will be distributed among investors.

ย 

Is preemptive right an obligation?

Preemptive rights are NOT an obligation for companies to provide, but rather a privilege and benefit offered to early investors.ย 

ย 

This means that the company is not legally required to provide preemptive rights, as they are typically granted at the discretion of the board of directors. However, offering this benefit can be beneficial to both the company and its current shareholders, allowing them to maintain or increase their ownership stake in the business.ย 

ย 

Additionally, preemptive rights can provide investors with the opportunity to benefit from future equity financings without disrupting their ownership stake in the company. For these reasons, preemptive rights are often seen as an attractive option for investors or for someone who might want to become a major investor.

ย 

What is difference between preemptive rights and right of first refusal?

Preemptive rights give early investors the ability to buy any new shares issued by the company before they are offered to outside investors. Right of first refusal grants shareholders the right of being able to match an offer made to another party for a sale or purchase.

ย 

Preemptive rights allow existing shareholders to maintain their ownership stake in the company by allowing them preferential access to new equity offerings, while right of first refusal does not provide this protection.

ย 

Additionally, preemptive rights can be subject to additional restrictions such as caps on how many shares each investor can buy and may not be offered at all if there is no need for immediate capitalization during future financings. On the other hand, right of first refusal gives investors more control over when they want to exercise their option since they have time prior the deal closing date in order to decide whether or not they will match an offer.

ย 

To learn more about other terms commonly used in venture capital,ย check out our complete VC Glossary.

ย 

Bottom line

Shareholder preemptive rights give stockholders the ability to maintain their percentage ownership in a company even if new shares are issued.ย 

ย 

If you own 100 shares of a company with 1000 total shares, you own 10% of the company. If the company then issues 100 new shares, you would still own 10% of the company if you had pre-emptive rights.ย 

ย 

Pre-emptive rights exist so that existing shareholders can maintain control over a company as it grows.ย 

ย 

Want better VC emails?