Preemptive rights provide investors with a right to maintain their proportional ownership in a company by participating in future offerings. They typically require the company to deliver preemptive right holders a notice of financing, within a specified period of time prior to commencing a new financing round during which period the investors can exercise their right to participate.
The failure to deliver the required notice, or follow the proper notice procedures, could result in unanticipated future dilution of the stockholders and/or monetary damages. A savvy investor who becomes aware of financing for which they were not notified, could wait and see if the company’s value significantly increases, and later claim a preemptive rights violation, making a claim for monetary damages, or for specific enforcement of their right to purchase shares on the price and terms of the prior round. In addition, the existence of preemptive rights could deter sophisticated investors from spending time negotiating to finance and engaging in due diligence, if existing investors have the right to take a substantial portion of the financing round.
Below are some ways to mitigate the risks of preemptive rights:
• Expiration Date: Set an expiration date, which could be based on time or a number of subsequent financing rounds.
• Majority Waiver: Incorporate a provision providing the majority investors with a right to waive the preemptive rights provision on behalf of all investors.
• Simple Notice Procedures: To minimize the risk of defective notice claims, provide simple notice procedures, including, permitting preemptive rights notices to be delivered by electronic mail.
• Short Notice Periods: Provide short notice periods, to minimize any delays in launching financing.
The information contained in this article is strictly for educational purposes and is not intended to be legal or tax advice or to be relied upon by anyone without doing their own research, and consulting with legal and tax advisors.