Preemptive Right of First Offer
Rights of first offer grant shareholders the right to purchase new shares issued by the corporation before others have the opportunity to purchase. The primary purpose of the provision is to allow current shareholders to avoid dilution of ownership by participating as purchasers of any new issuance of shares by the corporation. The provision generally allows shareholders the right to purchase an amount or percentage of new shares that equals to their current percentage ownership in the company (“pro rata” participation). The shareholder with preemptive rights must decline to purchase her pro-rata share before other investors can purchase those shares. 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 percentage of ownership directly affects return at time of exit, voting rights, and protective provisions.
Preemptive rights generally granted to preferred shareholders 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 oustanding.
- 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.
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.
Right 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.
Co-Sale rights are control provisions that protect the investor’s 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.