Preemptive Rights give whoever holds them the option, but not the obligation, to purchase additional shares in a company to maintain their ownership percentage during subsequent rounds of fundraising. They area form of dilution protection, an important concept for early-stage investors to understand.
Q. So here’s one of the many terms that’s become a lot more important because of the JOBS act.
A. Yes. As seed investing, and especially crowdfunding, becomes more important because of the JOBS act, this is a key issue to understand. Pre-emptive rights give holders the future right, but not the obligation, to purchase shares from a company in sufficient quantities to maintain the holder’s relative percentage ownership should the company if it issues new stock down the road.
Q. And, obviously, that will usually the case for seed stage companies. So these are a kind of “anti-dilution” rights.
A. Yes. Now, of course, not all dilution is bad: if the subsequent rounds are at a big premium to the valuation you invested at, it might be fine. But, if there’s a down round, or if the subsequent investor comes in with preferred liquidation rights, or if –as will often be true in crowdfunded deals — the company “issues stock like confetti”… you’ll want to have “pre-emptive rights”.
Q. But you’re not required to buy in to the subsequent round, right?
A. Right, its an option, sort of a like a call. That’s why its something you nearly always want to have as an early stage investor: its essentially a no-cost, very insurance policy that protects you against a big risk.
Q. And you mentioned that this can also be relevant to public companies?
A. Right. We’ve mentioned PIPES before in this segment, “private investments in public companies”. Nearly always, that PIPE investor will get significant pre-emptive rights for themselves, either through a preferred stock or via warrants. Sometimes those rights can get pretty nasty and be quite dilutive for existing common holders – who, at least in the US, typically do not have pre-emptive rights themselves.
Q. Anything else?
A. This is a very jusridiction-specific issue. In the UK, lots of this is covered by law; in Canada, its often in the common stock subscription agreement; in the US, can be in various corporate documents. Check with you lawyer, but, in early stage investing, make sure you’re covered.