Preemptive Rights

Cite this article as: Jason Mance Gordon, "Preemptive Rights," in The Business Professor, updated April 24, 2015, last accessed April 2, 2020, https://thebusinessprofessor.com/knowledge-base/preemptive-rights/.

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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. 

Preemptive rights related 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 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

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.

Academic Research on Preemptive Right

  • Preemptive Right of Shareholders to Subscribe to New Shares, The, Drinker Jr, H. S. (1929). Harv. L. Rev., 43, 586. The exact definitions of the judge-made doctrine of corporation law, known as the preemptive right, are misleading and not helpful. The reason is that the decisions cannot fully account for the established exceptions to the rule, which are based on practical convenience. The exceptions can only be understood by reviewing the casual development of specific cases. None of the decisions is asserted on a complete examination of the problem of recognizing the disparity between questions of practicality made on the endangered dilution of the stockholder’s current interest in assets and earning and those questions that come up dealing with the endangered dilution of the stockholder’s power to vote.
  • The Preemptive Right of Shareholders, Morawetz, V. (1928). Harvard Law Review, 42(2), 186-197. The doctrine of preemptive rights was first ratified by the courts because the proposed issue of extra shares under consideration in the cases was biased to the existing shareholder and violated the responsibility of the directors to exert their powers in good faith in the shareholders’ interest. Now, the doctrine has obtained the power of a fixed rule which grants preemptive right under specific circumstances, regardless of whether the issuance of the extra shares would be biased to the current shareholders or an act by the directors in bad faith.
  • Preemptive Right of Preferred Stockholders to Subscribe to New Stock, Hills, G. S. (1927). NYL Rev., 5, 207. The rule established by Stokes vs. Continental Trust Co. has been followed by the courts, which state that a stockholder holds a constitutional right to a proportional share of a new stock but the courts have not allowed a distinct differentiation of the rights of different classes of current stockholders. The preemptive right was solidly secured before the development of the contemporary preferred stock, which has various preferences, qualifications, restrictions, and designations way before shares without a par value was created.
  • How Can the Lessee Exercise Their Preemptive Right?[J], Meng-yong, D. A. I. (2004). Journal of Tsinghua University (Philosophy and Social Sciences), 4, 010. The PRC Contract Law provides the lessee with a preemptive right over leased buildings. The lessee can exert a preemptive right with identical conditions given in the contract between the landlord and the third party when the landlord sells the leased buildings. After the lessee applies its preemptive right, the landlord and lessee should draw up a sales contract. However, the lessee should not get the building’s title straight from the contract.
  • The Application of the Preemptive Right to Additional Issues of Corporate Stock, Spencer, E. A. (1942). J. Marshall LQ, 8, 376. Preemptive right got recognition early in American law but not as a special right but as a right that came from the various situations where shareholders could get the protection of an equity court.
  • Remedy for Denial of the Stockholder’s Preemptive Right, Adams Jr, E. W. (1950). Intramural L. Rev. NYU, 6, 126. The stockholder’s preemptive right is usually considered on the basis of a theory that the equity of the current stockholders in a company should be diluted or voting rights impaired without providing them with the chance to share in the new issues so they keep their position. Preserving voting rights is of significant importance in close companies since control is usually an issue. In some courts, the preemptive right goes as far as to ensure that the stockholder has a proportional amount of shares initially authorized but remaining unissued. It is not universal because some courts deny the extension.
  • Probe into the Legal Issues Concerning the Preemptive Right of Leasees of Lodge, Xiu-ling, W. E. I. (2003). Tribune of Political Science and Law, 3, 007. Only with formal and substantial conditions can a lessee of a lodge exercise preemptive right. It is a fair transaction when the equal condition is characterized by the price made under the one-time method of payment condition. The lessee’s preemptive right is a claim of property made by administrative control and laws but the bad faith litigation brought up by lessees under the premise of preemptive right should not receive any backing from the people’s court.
  • On the Competition of Preemptive Right [J], Ming, X. S. H. S. (2007). Journal of Political Science and Law, 2, 008. The phenomenon of multiple preemptive rights existing in the same object for sale and the conflicts that arise from it should be called competition of polymerizations. There are unique essential requirements and financially sound rules of preemptive right competition that depend on various conditions. Generally speaking, the preemptive right of the lessee should supersede the right of the joint owner.
  • Corporation Law: Exceptions to Stockholder’s Preemptive Right, Wall, P. (1962). U. Colo. L. Rev., 35, 482. The author examines the limitations of the so-called preemptive right of stockholders. Applying the doctrine to treasury shares, unissued, even if they are authorized, and unique questions of how the authorities apply are outside of what the authors wish to discuss. The author believes the problem is determining when a current stockholder would be deprived of the chance to purchase into a new issue of stock when the preemptive right doctrine normally applies.
  • The Conflicts and Solutions of Preemptive Right between the Lessee and Other Subjects [J], Meng-yong, D. A. I. (2004). Journal of Yantai University (Philosophy and Social Science Edition), 3, 008. When a lessee’s preemptive right comes in conflict with the preemptive rights of co-owners, county or municipal governments, the rule should be that the rights of the co-owners come before the rights of the lessees who should have priority over the rights of the municipal or county governments.  
  • On the Right Definition of the Stockholder’s Preemptive Right in the Limited-liability Company, ZHOU, G. J., & TANG, Y. S. (2004). Academic Exploration, 10, 014. To protect the trust interests of the stockholders, the company law gives the stockholders preemptive right. The regulation is solid, but when the stockholder exerts his or her preemptive right, is only part of the equity capital purchased and transferred by the other stockholders? The author believes that equal conditions should include equal prices and equal numbers. The stockholder should not be allowed to purchase only part of the equity capital transferred by other stockholders when he or she applies a preemptive right.   

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