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Pre-Emptive Rights – What are they and what do they mean for start-ups

pre emptive rights

Pre-emptive rights give some shareholders or equity holders the opportunity to purchase a number of newly issued shares for a limited period before they are offered externally to potential new investors.

When a start-up seeks to raise further expansion capital through issuing fresh shares, the current owners can maintain their proportional stake and influence in a business. Without this step, new investors could dilute the ownership of the business.

Essentially, pre-emptive rights are the offer of first refusal for new shares in an existing company. These rights are commonly attached to preferred classes of shares held by venture capital firms who invest in high-growth start-ups.

How Do Pre-Emptive Rights Work?

New shares can be issued in incorporated companies when they want to raise capital from external investment. Pre-emptive rights act as an optional protection that can be issued by the company to certain shareholders. This protection gives affected shareholders the right of first refusal for new shares, before they become publicly available.

Not all shareholders automatically have these rights so here is an overview of who is and isn’t entitled.

  • Pre-emptive rights must be specifically assigned to a shareholder in the company’s constitutional documents.
  • Major investors are the parties that typically secure these rights. For example venture capital firms or shareholders with large minority stakes.
  • Pre-emptive rights usually go hand-in-hand with preference shares that are issued to institutional investors. This is in contrast to ordinary shares that are most often held by employers and smaller investors.
  • The articles of incorporation can detail and adjust exactly which class of share can carry pre-emptive rights when they are initially set up.
  • Most pre-emptive rights have a limited time window meaning that they expire after a number of funding rounds.

For example:

  • Investor A holds 20% of current shares in Start-up B.
  • Start-up B is now raising a new round issuing 1 million fresh shares, diluting existing holders. With pre-emptive rights,
  • Investor A has a time-limited option to buy 20% of 1 million shares made available – that’s 200,000 shares in this case.

This allows them to effectively maintain their overall 20% total holdings, resisting dilution from new shareholders brought in by the fundraising round. It protects their position.

The exact calculation varies but is often structured on a pro-rata basis mapping to current percentages held by those shareholders with assigned rights.

A 30-60 day execution window is commonplace for existing shareowners to buy new shares before they are offered externally.

What Is A Start-up?

A start-up is a new, early stage business that is in its infancy. These ventures usually have the goal of developing a product or service to build a company around.

  • Start-ups are brand new companies often with little revenue at first
  • Usually with a small founding team and employees trying to get the company off the ground
  • Their main focus is getting the companies product or service in front of customers
  • Most require external investment to really get going because they don’t yet make enough profits of their own.
  • Often start-ups have a level of uncertainty around the idea of their business as they don’t know if it will flourish or fail.
  • Those that succeed, often go on to experience huge growth and become large companies. Examples include Facebook, Uber, and Airbnb.

In summary, start-ups are brand new ideas and early stage business ventures based on unproven but innovative ideas and concepts. They require funding to get going, often have great potential but face uncertainty in how successful they will be.

Pre-emptive Rights: Benefits For Investors

There are several advantages that pre-emptive rights carry for investors in private equity backed start-ups:

  • They help maintain proportional control and influence as companies scale up. This helps to avoid sudden shifts in power from unexpectedly large funding rounds which could have a big diluting impact on existing shareholder positions and power.
  • Company cash reserves don’t need to be hastily invested when the price of shares escalates quickly in a short period of time. This means strategic capital spending can be maintained.
  • When startups get sudden investment, their valuations can rise quickly which can lock existing investors out from reinvesting. The pre-emptive approach prevents valuations escalating too quickly in the growth phase meaning that early investors can continue investing through funding rounds at levels that are aligned with their early investment rather than inflated levels created due to hype based spikes.

In short, pre-emptive rights are beneficial for investors because they prevent them from getting priced out and unable to reinvest in their companies should they become overvalued due to exponential growth.

Drawbacks and Limitations Of Pre-emptive Rights 

The main downsides to pre-emptive rights for start-ups are:

  • They can slow down external fundraising as they give existing investors additional time to decide if they will invest more or not.
  • Keeping track of investors and what they can and can’t invest takes a lot of administrative work.
  • It’s hard for startups to predict how many existing investors will want to invest again and how much they will want to invest. This makes reserving shares for them an unknown quandary.
  • If early investors put in small amounts, further funding rounds may cost more than they can afford. This could slowly reduce their level of ownership in the company over time as more funding rounds take place.
  • Using pre-emptive rights to favour existing investors may result in missing out on new, fresh investors that could bring greater benefit to the business in its next stage.

You can see therefore that shareholders must weigh up the pros and cons of pre-emptive rights when setting their constitutional documents at company formation.

Are Pre-emptive Shares Used In Businesses Other Than Start-ups?

Yes, pre-emptive shares are also relevant for more established privately owned companies.

  • Pre-emptive shares give existing shareholders the first rights, options, or warrants to purchase newly issued shares to maintain their proportional ownership. This is a way for them to avoid dilution.
  • While most commonly discussed in the context of startups and venture capital rounds, pre-emptive rights can apply to any private company issuing new shares.
  • They allow existing owners to preserve influence over the business and benefit from continued growth. This applies not just to founders/investors, but any private business owners.
  • For larger mature private companies, issuing new shares could be to raise growth capital, provide employee stock options, bring in specialised investors, or facilitate ownership transfers.
  • Pre-emptive rights in these cases allow existing owners, founders, partners, families etc. to maintain control rather than being diluted when ownership stakes are reallocated.

So while typically more emphasised in startups and VC-backed companies, pre-emptive share rights help existing owners in any private company defend their proportional ownership when new shares are issued, whether for raising capital, employee incentives, investor onboarding, or ownership transition.

Alternative Options To Pre-emptive Rights For Startups

While pre-emptive rights offer some strong protections particularly in the early startup stages, founders of such companies may want to reduce or remove these provisions in favour of other, more flexible alternatives.

Investor Approval Provisions: This option ensures that any investors that own over 50% of the shares must give their approval before new shares can be issued. This is helpful in avoiding company ownership dilution without limiting its growth.

Convertible Loan Instruments: Startups can raise money through convertible debt that later turns into shares as an alternative to issuing new shares. This avoids the administrative process of repetitive paperwork and calculations around ownership rights. The terms of the conversion of the debt to shares would be fixed at the point of signing the loan deal.

Milestone Share Agreements: This option allows select investors to pre-approve buying certain numbers of shares at a pre-set value when funding and growth milestones are reached. This reduces the uncertainty that comes with inviting external investors and reduces the time taken for price negotiations at each round of funding.

When considering pre-emptive rights and alternatives, startups need to weigh up the flexibility vs investor protection offered. There is no one-size-fits-all solution and each company will be suited to different provisions around shareholder ownership and further investment as the company grows.

Structuring Terms in Startup Incorporation Documents

When setting up a business, company founders need legal frameworks in which to operate. This is known as ‘incorporation’ and requires some key documentation including:

  • Articles of incorporation: This is the legal charter that declares the creation of the corporation, its purpose, structure and ownership details.
  • Bylaws: These are the rules that govern how the company operates
  • Shareholder Agreements – this sets out the proportion of shareholder ownership, their rights, and details.

These are legally binding documents that get filed with companies house in the UK.

Why Are Pre-emptive Rights Set Here?

Pre-emptive rights are set at the incorporation stage where shareholder rights are defined. This includes whether pre-emptive rights are given and ensures that current and future shareholders are protected from company dilution risk in a manner agreed up front.

How Are The Terms Set?

The proportion of new shares that existing shareholders can purchase and how long they have to make the purchase are usually set out at this stage. Methods for determining share price can also be defined here too.

A lawyer will set up the legal wording for the rights during the incorporation stage as per the company founder’s wishes.

Frequently Asked Questions On Pre-emptive Rights

What terms are used when setting pre-emptive rights?

  • Key terms defined in pre-emptive rights include:
  • The timeframe to exercise the rights (typically 30-60 days)
  • The price per share or how the price will be determined
  • The proportion of new shares that can be purchased
  • Any limits on subsequent funding around these rights

Can founders and employees hold pre-emptive rights too?

Pre-emptive rights are not exclusive to investors. This means that founders and employees who hold common stock can also be granted these rights if specified in the incorporation documents that allow them to hold ownership stakes.

What compliance is required for pre-emptive offers

Companies must formally notify eligible shareholders when shares are going to be issued and provide full transparency on the process, number of shares to be issued and if any pre-emptive rights exist.

Are There Alternatives Available To Balance Founder and Investors Rights?

Other arrangements like secondary sales, pro rata rights and staged vesting can help to balance founder and investor shareholder rights. Expert legal advice is essential to craft terms suiting the founder -invest relation vision and context.

Finally,

Preferential pre-emptive rights enable private shareholders to hold on to their proportion of ownership when future funding rounds take place for start-ups and other incorporated businesses.

These rights help to balance company ownership control with the need for additional funding and the mechanisms for them are outlined in shareholder agreements.

With open communication and legal diligence, pre-emptive rights can create a fair standard for start-ups to manage their expected growth and investor relations around.

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