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How do pre-emption rights affect investor dilution?

How do pre-emption rights affect investor dilution?

4th April 2017 by Clement Bigot

At Seedrs, we enable investors to share in the success of the businesses they choose to invest in. A key part of that is ensuring investors’ interests are sufficiently protected. One of the ways we protect investors is by securing certain contractual rights in our investment agreements with funded businesses. These agreements contain similar terms that most angel investors and venture capital firms would expect. This blog post explains the basics of one of those contractual rights called “pre-emption rights”.  

Pre-emption rights ensure that existing investors have the right (but not the obligation) to invest in future fundraising rounds of the company in order maintain their level of shareholding in a company.

To understand why pre-emption rights matter it’s important to understand the concept of dilution and the affect it has on ownership.

Every time a company raises funds by selling equity, the company issues shares to new investors in exchange for their investment. In turn, this reduces the percentage share of ownership for each existing investor in the company. It’s like the investors have a smaller piece of a bigger pie, over time. This process of having your percentage ownership reduced when new shares are issued is called dilution.

Dilution in actionshare dilution exampleIf a company continues to raise additional funds and issue more shares, dilution can have substantial effect on an early investor.  As they own less of the company, they are entitled to a smaller portion of the company’s proceeds.

seedrs-dilution-exampleAfter multiple funding rounds, early investors who initially received large stakes in the business may find themselves with much smaller holdings when the company looks to exit or IPO.

Why is pre-emption so important?

This dilution effect is why pre-emption rights are so crucial for early-stage investors. Pre-emption gives investors the opportunity to invest in each future investment round in order to maintain their percentage ownership. In effect, it allows them to keep their slice of the pie the same size.

Pre-emption rights are also an important minority shareholder protection; they disincentivise the majority shareholders from issuing new shares to themselves at a low valuation. If they were to do so, they would have to offer the low value shares to all shareholders.  For that reason, they are often seen by investors as the most crucial minority investor protection.

Investors don’t have to take advantage of pre-emption. At Seedrs we believe they should be given the opportunity to in most cases, unless there are legitimate business reasons for the rights being waived.

Pre-emption rights at Seedrs

Seedrs seeks secures pre-emption rights for investors and provides the practical facilities for investors to exercise these rights.  Running a pre-emption round for 100+ shareholders would be impractical for most small businesses. However, the Seedrs model streamlines the process and makes it possible for all investors to participate via the Seedrs platform. Seedrs takes care of calculating investors’ pre-emption rights, contacting investors about the pre-emption round and running the private pre-emption campaign. This allows the company to get on with raising funds and growing the business.

While dilution can be seen as negative, it’s important to remember that, generally, additional fundraising means that a company is doing well and increasing in value. An investor may be holding a smaller piece of the pie, but the pie is usually getting more valuable. You can read more about why dilution isn’t always bad here.

Pre-emption rights are industry standard for professional investors in early-stage businesses such as VC’s and angels. However, not all equity crowdfunding platforms can secure them for you. At Seedrs we think that all investors, no matter their size should be able to protect their holding in a business as it grows. This is one of multiple ways that Seedrs ensures that all investors can be part of a company’s success.

Clement Bigot

Investment Associate at Seedrs

Digital Agency Kent