Venture Capital Term Sheet: Preemptive Rights
What are Preemptive Rights?In addition to the provisions discussed previously to limit dilution, investors will often request preemptive rights or a right of first refusal as a tool to allow the investor to maintain its ownership percentage. Preemptive rights will generally involve a contractual right to purchase additional shares in the company's next offering in order to maintain the investor's percentage shareholdings - usually the pro rata share. However, in some cases, the provisions provide that the investor has the right to purchase any future shares the company will issue, even in excess of their pro rata amount.
What should you watch for regarding preemptive rights or rights of first refusal?Preemptive rights can cause some complications for a company raising additional funds, as the company must offer a portion of the additional investment to its current holders which can raise certain hurdles in adding a strategic investor or a new investor. As a result, if the investor requires preemptive rights, it is usually in the interest of the company to try to limit this right to only the purchase of a portion of the shares offered in the next round sufficient to maintain an investor's pre-financing shareholdings on a fully-diluted basis. Preemptive rights should include language terminating the right prior to an initial public offering to prevent any problems that would result in a general sale of securities.
Equipment Lease LinesOne key point on the right of first offer is to preserve the company's flexibility to engage in transactions such as equipment lease lines with warrant coverage without having to get waivers from the investor group.