Preemptive Rights . . .

are entitlements that existing shareholders have to purchase new shares of stock issued by a company. In some states, these rights automatically exist unless the company’s articles of incorporation specifically waive them. In other states, they do not exist unless they are specifically granted in the company’s articles of incorporation. Preemptive rights can also be created by contract and are frequently requested by venture capital investors.

Preemptive rights complicate fundraising. By forcing a company to offer its shares to existing shareholders before it offers them to outside investors, these rights can postpone the sale of company shares to outsiders. Because preemptive rights require company shares to be offered pro rata among existing shareholders, they can also delay funding from an existing investor by requiring the company to first offer a percentage of the shares the investor wants to purchase to the other existing shareholders. If any of the existing shareholders exercise their preemptive rights, the new investor may decide not to provide funding because there are not enough shares left to purchase.

Often, companies with preemptive rights fail to follow the statutory or contractual procedures when issuing new shares. This can make it difficult to determine what preemptive rights each shareholder is entitled to receive. Since the company cannot issue shares that are subject to preemptive rights without first offering them to the existing shareholders according to their rights (at least, not without incurring liability), not knowing what those rights are can create a barrier to obtaining funding. Untangling such a mess can be costly and time-consuming.

Sometimes preemptive rights are ignored or forgotten until the company is ready to go public. At that time the underwriter will insist on assurances from company counsel that the company can sell its stock to the general public. If existing company shareholders have preemptive rights, company counsel may be unable to give that opinion without first taking expensive and time consuming steps to cure the problem. In some cases, a practical cure may not be available. See: Antidilution Provisions, Charter, Dilution (Percentage), First Refusal Rights (shareholders).