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Pre-emption: The important right that can save you from dilution

Pre-emption: The important right that can save you from dilution

16th February 2018 by Shameel Khan

Join any discussion on investing in early-stage businesses and startups and sooner or later pre-emption will be mentioned. If you’re an investor, read on to find out everything you should know about this important right.

What does pre-emption mean?

Pre-emption rights enable existing shareholders of a company to purchase new shares in it before they become available to new investors. That means you could avoid dilution and enjoy greater returns, as the example further below shows.

Who cares?

The original investors should care very much because having pre-emption rights means that they can maintain the same percentage of equity that they have before the new shares became available.  That means that they can avoid having their equity in the company diluted, but will require the investor to make further investments, as the ‘With pre-emption’ example below illustrates.

So, for example, let’s say that you own 2% at a £10m valuation.  The company goes through a further couple of rounds over the next few years, before exit. Our notional investor doesn’t have pre-emption rights, so he is not able to make further investments that would maintain the 2% shareholding. Still, he originally invested £200,000 and he still has 1.33% of the company, so the value is now £2M – a profit of £1,800,000.

Our second fictional investor invests £200,000 in the first round, a further £100,000 in the second round and another £200,000 in the third round, which maintains his 2% shareholding. That makes a total investment of £500,000 with a total value of £3M – a profit of £2,500,000.

Of course, this right only becomes really valuable if the company becomes successful. But it means that the original investors have the opportunity to fully share in the company’s success.

Can pre-emption be also used to disincentivise a company from issuing more shares ‘on the cheap’?

Yes, it certainly can be used be used in a defensive application. Here’s an example that explains what could happen without pre-emption rights:

  1. A company has 100 shares. Your investment bought you one share out of the 100, so you own 1% of the company.
  2. The company goes on to become extremely successful. It’s going to be sold for £100m next week. You work out that you could get around £1m.
  3. Without contractual pre-emption rights, the entrepreneur could issue 1,000,000,000 new shares the day before the company is sold. Then buy them all for £1. Without pre-emption rights, you can’t buy any of them yourself. So now, instead of owning 1% of the company, you own 0.0000001% of the company and will be paid £0.10.
  4. You no longer feel like celebrating.

Who’s eligible to invest in a pre-emption round?

 The shares offered in a pre-emption round can only be offered to existing shareholders, who have pre-emption rights. However, pre-emption rights may not apply to all shareholders.

Do I automatically get pre-emption rights?

This will depend to a large extent on how you purchased equity in early-stage companies.

Technically, all shareholders have pre-emption rights under company law, unless dis-applied in the Articles of Association (the rules by which the company is run). Most Articles of Association for companies dis-apply the statutory pre-emption right but instead set-out a pre-emption process which does apply.

At Seedrs, we do not just rely on the pre-emption process set out in the Articles as these can be easily eradicated. We automatically include pre-emption in all the investment agreements between us (as Nominee) and the companies selling equity. So even if a company altered the Articles of Association, its obligation to the investors under the Seedrs nominee arrangement would still stand. However, in a few rare instances, that right may be waived by an investor majority.

Do I have to buy the shares I’m offered in a pre-emption round?

Not at all. But note, when a company releases additional equity, the new shares being issued will reduce the percentage share of the company owned by an individual investor. So, in other words, your equity in the company will be diluted.

How much are shares in a pre-emption round?

Shares in a pre-emption round are at the same share price that new investors are offered.

If I don’t buy shares in a pre-emption round, will the resulting dilution have an impact on my potential returns?

 Yes, because not maintaining your equity percentage by buying the shares offered will reduce your percentage of the equity. However, the fact that a company is ambitious and is looking to go through further funding rounds is (generally) positive. It could lead to the company rapidly growing – and it could quickly grow in value.

To use an analogy, if there’s an exit, although through dilution you’ll have a smaller percentage of the pie, that pie could well be a lot bigger and your stake in it should be worth more than before.

Shameel Khan

Shameel works with entrepreneurs throughout the fundraising process as well as focusing on post-investment matters for our portfolio companies. He previously worked at Raileasy, an online rail ticket retailer and the accountancy firm BDO.

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