Understanding Investor Rights — Pre-emptive Rights

When a company intends to raise more funds by issuing new securities or other financial instruments, more often than not, it typically necessitates a detailed shareholders’ agreement (SHA). Such agreements are essential for safeguarding the interests of the shareholders.

Lot of deliberations and negotiations take place in order to arrive at a mutually agreeable outcome. These negotiations, however, cannot be left to assumptions and general intent of the parties involved.

This is where the drafting of SHA assumes much importance to capture the rights and obligations of the parties accurately.

Let us delve into one such crucial provision in the SHA: Pre-emptive/Pre-emption Rights of an investor.

This refers to the right available to some of the existing investors (Pre-emptive right holders) to be offered the first opportunity to subscribe to securities, before they are offered by the company to any other or external investor.

This provision ensures that the pre-emptive right holders have the opportunity to maintain their proportionate or pro-rata ownership stake in the company on a fully diluted basis, if they wish to do so. Thus, if the pre-emptive right holder before the issuance owns 10% of the company, they have the right to buy up to 10% of the new securities being issued to maintain the same stake in the company on a fully diluted basis.

Further, it is a right and not an obligation of such an investor to necessarily participate in the new issuance, either fully or partly.

Significance of Pre-emptive Rights

The investors typically ensure that the key rights including Pre-emptive rights are available to them, while the founders make sure that they do not give away too many rights or rights without restrictions that might have the effect of restricting their ownership and control in the company.

One may wonder why it is so important for investors to include this right in the SHA.

To understand this further, let us explore a scenario where the pre-emptive right is not available to the investor. In this case, the issuance of new securities would not only reduce the stake of existing investors but also leave the investors at a disadvantage. This is due to the reason that many other rights are available to the investors based on their stake in the company and as the stake reduces, the rights tend to fall-away.

To take a hypothetical example, if given a particular threshold, the investor enjoys certain rights, among others, as in:

• Right to appoint its representative director (investor director) on board of the company.
• Right to receive key information from the company on a monthly/quarterly basis
• Right to restrict the transferability of founders’ securities
• Right to drag the founders in certain events of default
• Right of first refusal (ROFR) etc.

In this case, let us assume that post issuance of securities by the company, the investor’s stake is diluted below the threshold, thus the investor would lose all the rights above that it has enjoyed thus far.

In every new funding round, the investor’s stake would keep getting diluted further even up to the point of becoming a minority investor who has no say in the decision making of the company.

The investors, hereby, ensure that such rights are available to them, at all points in time by including relevant provisions in the SHA.

Exceptions to this Right

It must be noted however that there are certain instances where the Company can proceed with the issuance of new securities without first offering them to the existing investors.

These exceptions commonly referred to as “Exempted Issuances,” are specified in detail within the SHA. They commonly involve dilutive instruments issued by the company under a stock incentive plan for employees, or as part of an initial public offering (IPO), or through a stock split or conversion of convertible instruments, among other scenarios.

Challenges for the Company

In the foregoing paragraphs, we discussed how important it is for the investors to ensure their ownership stake in the company as and when a company expands and grows.

While the pre-emptive right is advantageous for the investors, it may not always be beneficial for the founders or the company, especially when the company explores strategic alliances, pre-emptive right if fully exercised by the existing investors may limit the company’s ability to raise additional capital and benefit from a strategic collaboration for growth and expansion.

Further, the whole process from offering to issuing pre-emptive securities can involve considerable time, besides requiring legal compliances. This may be a critical factor to consider if the company needs funds sooner than later.

Takeaway

To sum up, allowing the existing investors to have Pre-emptive rights among other rights enable the founders to procure funding from the investors with relative ease. Having said that, the founders are particularly cautious about who they should be giving these rights to in preference to others.

The existing investors on the other hand feel much more confident about their investment and collaborate in the future rounds of funding if their stakes in the company are maintained.

Thus, understanding these provisions and balancing the interests of all stakeholders is crucial to ensure that all the parties involved are fully cognizant of their rights and obligations, empowering them to navigate the complexities of securities issuance with clarity and confidence.

Author

Mansi Handa