After recent discussions with some of our subscribers it occurred to me that many of our readers may find some very common industry terminology daunting and/or confusing. Mark and I recently participated along with our Seraph members in a deal whereby we had the opportunity to take up pre-emptive rights, which is what brought the topic to the fore.
What Exactly are Pre-emptive Rights?
Sometimes called subscription rights as well, these are pretty common in private equity and VC (Venture capital) deals. A pre-emptive right gives you as an existing shareholder the right to acquire new shares issued by a company. For example, after a round of VC financing by Series-A investors, if the company decides to issue new shares to potential Series-B investors, the Series-A investors will have the right to acquire shares up to their pro-rata shareholding. This helps ensure that Series-A investors can, if they so choose, retain their voting power even if the company decides to issue new shares in the future.
Pre-emptive rights allow early investors to ensure that they have the ability to retain their ownership share on a pro-rata basis and not be diluted. These rights do not need to be taken up, and act more like an option contract than a futures contract in that respect.
Why Would an Investor Want This?
This gives us, as investors the right to participate in subsequent financing rounds to the extent that is required to protect our percentage equity stake. If the company is executing and doing well, this provision can be immensely valuable. When the company then goes to raise capital for its institutional round of financing the dilutive effects of that raise are mitigated by early-stage investors taking up those pre-emptive rights.
Dealing with Shady Venture Capitalists
I will say that I’ve had deals whereby VC’s come in and attempt to kill the pre-emptive rights previously agreed upon. This is incredibly frustrating for all parties. The founders find themselves stuck between a rock and a hard place as they don’t want to annoy seed investors (you/us) and they don’t want to annoy the VC’s either and risk losing the deal.
My own personal attitude when this happens is that the VC’s can go to Hell, suck eggs and eat s#!^, but I’m a nice guy, so I’m not sure how others deal with it. We do our damnedest to NEVER deal with unethical people, and when VC’s try to do that it is unethical…plain and simple. Of course if the rights are written into a contract then they’re enforceable, and as early-stage investors with those rights you can enforce and should enforce them.
From the founders perspective what they need to consider is the company they keep. Angel investors and VC investors are often much, much more than simple shareholders. This is a partnership and it’s certainly not uncommon for angels and VC’s to play a significant part in the strategy of any young business. In other words early-stage investors are not always passive. Do you as a founder really want to be keeping company with people who are unethical and willing to run roughshod over existing shareholders if given the chance?
What About “Anti-dilution Provisions”?
Anti-dilution (not to be confused with antediluvian) provisions allow for early-stage investors to retain their percentage ownership in a company in the event that future financings would dilute them. Shares, options and convertible securities are adjusted so that the holder of these securities receives additional securities.
It is typical that anti-dilution rights apply to financings done at a lower valuation to that which the investor has originally participated. Where financings are done at a higher valuation what typically happens is that the angel or early-stage investor, though diluted in percentage terms is realising an accretive dilution. This is often where pre-emptive rights become valuable. Just remember that the shares, options or convertible securities originally purchased are worth more even though the share count has risen in the event of a subsequent capital raise at a higher valuation.
We hope this little “cheat sheet” on these relatively simple terms helps. If you have any questions fire away!
“If you are not willing to risk the unusual, you will have to settle for the ordinary.” – Jim Rohn