This post is the twelfth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.
In the prior eleven posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, explained how liquidation preferences work, discussed the conversion rights and features of preferred stock, examined voting rights and investor protection provisions, analyzed anti-dilution provisions, looked at anti-dilution carve-outs and “pay to play” provisions, described redemption rights, and examined registration rights, and looked at management and information rights. In this post, we will discuss preemptive rights.
The word “preemptive” in “preemptive rights” refers to the purchase of a company’s new shares before they are offered to anyone else. The National Venture Capital Association (NVCA) term sheet (here) includes a sample preemptive rights provision, titled “Right to Participate Pro Rata in Future Rounds.” This provision entitles investors to participate in later securities issuances on a pro rata basis (assuming conversion of all preferred stock). The right can be limited to investors who hold a certain large amount of preferred stock. The right does not apply in the case of issuances that are excluded from issuances that trigger the anti-dilution adjustment, such as stock issued upon the conversion of preferred stock or stock issued as part of an equity compensation plan (see post on anti-dilution provision carveouts). If an investor chooses not to purchase its entire pro rata share, the other investors can purchase the remaining shares pro rata. This provision enables investors to maintain their original percentage ownership and avoid dilution if they choose to do so. (Contrast this with anti-dilution provisions, discussed here, which enable investors to avoid dilution of the value of their investment, as opposed to their percentage ownership.) Maintaining percentage ownership can be key to an investor keeping certain voting rights, board appointment rights, or the information rights discussed here, if those rights are conditioned on a certain percentage ownership.
Preemptive rights provisions might incorporate a “pay to play” feature, like the ones anti-dilution provisions sometimes have (discussed here). If an investor does not participate in a subsequent financing round, exercising its preemptive rights, certain penalties may apply, such as the conversion of its preferred stock into common stock at the pre-issuance conversion price. As with anti-dilution provisions, a “pay to play” feature gives investors an incentive to participate in future rounds.
Founders should be aware that preemptive rights provisions are standard and venture capital investors will expect to see them in the term sheet. They are not worth spending a lot of time negotiating. Founders should simply be careful that the investors don’t attempt to make these provisions too onerous, for example by adding terms that are broader than the ones in the NVCA term sheet, such as terms giving an investor the right to purchase any and all shares the company issues in the future, rather than just its pro rata share, or terms that do not include the customary carveouts referenced above.
In the next post, we’ll discuss drag-along rights.
Read more articles by Alexander Davie at Strictly Business, a business law blog for entrepreneurs, emerging companies, and the investment management industry.
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