What is a Pre-emptive Rights Clause?

Pre-emptive rights clauses can protect existing shareholders from the dilution of their proportionate holdings, and is a type of protection sought by founders and investors alike. The term ‘pre-emptive rights’ usually refers to a ROFO (Right of First Offer). These clauses can be found in various agreements, most commonly shareholder agreements, subscription agreements, and operating agreements.

A Right of First Offer (ROFO) gives the shareholder (an existing investor) the first opportunity to purchase new shares that the corporation offers for sale, in proportion to the amount of (voting) shares already owned by the investor. If the shareholder has the funds and wishes to increase their investment, this pre-emptive right can prevent new investors from reducing or diluting the ownership percentages of existing shareholders.

A similar mechanism can be used to protect shareholders’ relative proportionate holdings when another shareholder wishes to sell its shares, particularly in a private corporation. A Right of First Refusal (ROFR) gives non-selling shareholders the right to purchase the shares of a selling shareholder (a shareholder who wishes to sell all or part of their shares), before those shares can be offered to persons who are not existing shareholders. Founders will often have a ROFR, to enable them to take over the business if a co-founder wishes to leave, to prevent hostile takeovers, and to protect themselves from having to share control of the corporation with a ‘stranger’, or worse, a hostile competitor. The effectiveness of the ROFR to protect existing non-selling shareholders depends on the financial ability of those shareholders to purchase the sale shares. Other mechanisms, including piggy-back rights, drag along rights, and co-sale rights can be combined with the ROFR, depending on the nature of protection desired by the shareholders.

Example of a Right of First Offer

To provide an example, let’s assume HoundCo has issued 500 shares. You purchased 50 of them so you own 10% of the corporation. You are hoping to continue to own 10% of the corporation going forward. If HoundCo decides to offer another round of equity financing and offers another 500 shares for sale, you would be entitled to buy 50 of them again if you had a pre-emptive rights clause. If you have the funds, and exercise your pre-emptive rights, you retain your 10% ownership in HoundCo. If you didn’t have the pre-emptive rights, or chose not to exercise them, then after the 500 additional shares have been sold your equity would drop to 5%. If more rounds of financing occur you could see your percentage ownership continue to drop. That is why the pre-emptive rights clause can be so important to investors.

Who do they benefit?

Pre-emptive rights benefit the shareholder who is receiving the right. They have the opportunity to continue to buy shares in the corporation if they wish to maintain their proportionate share in the company. If the shareholder doesn’t have the funds, or does not wish to continue to invest and buy additional shares in the company, then they do not have to exercise the pre-emptive rights. The clause simply gives the investor the opportunity.

An early stage corporation may be hesitant to grant pre-emptive rights (ROFO) to investors if they are hoping to attract a major investor later on, because it could be difficult to offer a large enough percentage of the corporation to the major investor without disproportionately diluting the holdings of the founders. The pre-emptive rights mechanism can also create delays for the corporation in raising funds with a new issue, as the corporation will have to wait to see whether shareholders exercise their rights before offering the shares to other investors.

Take-aways:

  • Enables shareholders to maintain their proportionate holdings by purchasing additional shares if they are offered for sale (either from the corporation under a ROFO or from other shareholders under a ROFR)
  • Pre-emptive rights don’t force a shareholder to buy additional shares
  • Benefits the investors (shareholders) not the corporation

Written by Chris McIvor

 

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This article is provided for informational purposes only and does not create a lawyer-client relationship with the reader. It is not legal advice and should not be regarded as such. Any reliance on the information is solely at the reader’s own risk. Clausehound.com is a legal tool geared towards entrepreneurs, early-stage businesses and small businesses alike to help draft legal documents to make businesses more productive. Clausehound offers a $10 per month DIY Legal Library which hosts tens of thousands of legal clauses, contracts, articles, lawyer commentaries and instructional videos. Find Clausehound.com where you see this logo.

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