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February 17, 2025
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Venture Funding is a high risk and a high stakes game where the power law operators ruthlessly. Historically, only a small percentage of investments offer outsized returns to the venture capital investors. Now to maximise investor value in this paradigm, an investor would prefer to keep investing in companies that appear to be winning (read: able to raise follow-on funds) over time, as business models get de-risked and companies start generating revenue and profitability.
This ability of an investor to continue investing in a company’s future funding rounds at their choice is structured as a pre-emptive right or pro-rata rights. Let’s decode this further.
Pre-emptive rights allow existing shareholders, particularly early investors, to participate in future financing rounds to keep their proportional ownership intact. This mechanism is crucial for investors who want to avoid dilution of their stake when new shares are issued. It's like having the first dibs on the next round of betting on a horse that's already showing signs of winning.
Pre-emptive rights are typically given to the extent of the proportional shareholding of a stakeholder. For example, if a shareholder owns 10% in a company, as part of pre-emptive rights, this shareholder is offered new shares to the extent that the shareholder is able to retain their 10% ownership post the issue of shares in the new financing round.
Hence, this right is also referred to as Pro-Rata rights, as existing shareholders are offered pro-rata shares to the extent of their percentage holding.
Assume Company A has 100 fully diluted shares outstanding. Investor X has 10 shares implying 10% ownership in the company.
Before New Investment Round
Company A Shares: 100
Investor X Shares: 10
Investor X Shareholding: 10%
Let’s assume a new investment round where the company intends to issue 20 new shares to new investors. Let’s assume Investor X doesn’t exercise pro-rata rights:
After New Investment Round without Pre-Emptive Rights:
Company A Shares: 100+20 = 120
Investor X Shares: 10
Investor X Shareholding: 8.33%
As you can see, Investor X’s shareholding drops to 8.33% in this case. In order to avoid this dilution, Investor X can exercise their proportional pre-emptive right to subscribe to 10% of the new issuance:
After New Investment Round with Pre-Emptive Right Exercise
Company A Shares: 100+20 = 120
Investor X’s Pro-Rata Right: 10%
Investor X’s Pro-Rata Shares: 10% x 20 = 2 shares
Investor X’s Shares Post Investment: 12
Investor X Shareholding Post Investment: 10%
In this way, Investor X in this example is able to subscribe to 2 additional shares in the new round to retain their ownership in the company.
The obvious reason of course is to retain their stake and hence improve their chance of unlocking a large value if the startup does well. Also the fact that the startup is receiving investor interest for next round financing itself is arguably a proxy that the startup is doing well.
Exercising pre-emptive rights also empowers existing investors to be at the driver’s seat while negotiating rights in the new SHA. Typically every new SHA tries to override the rights given out to investors previously and re-triggers rights giving the latest investors precedence. This is typically in case of board seats, liquidation preferences, anti dilution, exit rights among many others. If an existing investor doesn’t participate in the new round, the extent to which they can negotiate to retain some of these rights would be limited.
Hence, apart from ownership, participating in the subsequent round also enables existing investors to remain relevant from a rights and control standpoint!
These are rights for investors to subscribe to shares larger than their proportionate holding. These are rare and founders should definitely negotiate not having it.
In certain rare cases, when it's a strategic investor (like a corporate or a larger startup) who is participating in early rounds with a definite acquisition interest (explicitly or implicitly), there might be a case of Super Pre-Emptive right that they would seek.
Only offer it to strategic investors. Remember the more stakeholders you offer this to, the more process related work you will have in terms of issuing them a notice and waiting for their response.
Well known funds typically invest across stages. They enter at an early stage (many funds invest at a seed stage) and continue to invest as part of their pro-rata rights later stages as well. This works in the favour of the startup as it sends out a positive signal to incoming investors as an existing investor is willing to increase their investment.
Hence, if you have such a strategic investor on your captable, ensuring that they subscribe to atleast part of their pre-emptive right shares might not be a bad strategy!
To sum up, pre-emptive rights are designed to keep the "winning horse" within the stable of those who first believed in its potential. They're about more than just maintaining ownership; they're about commitment to the vision and growth of the startup. However, like any powerful tool, they require careful handling to ensure they serve the long-term interests of both the company and its investors.
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