Venture Capital Term Sheet Negotiation — Part 12: Preemptive Rights

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, 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.


© 2014 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

About Alexander Davie

Alexander Davie is a corporate and securities attorney based in Nashville, Tennessee. Businesses of many varieties rely on his counsel and judgment throughout all stages of their growth. In particular, fund managers and investment management professionals seek the expertise Alex gained when he served as general counsel to a private investment fund. Alex also has significant experience and enjoys working with companies and entrepreneurial ventures, especially within the technology industry. As a believer in technology's ability to enrich people's lives and allowing people to connect with each other in new ways, he is passionate about helping tech startups achieve success. He is active in Nashville's startup community as a mentor at the Nashville Entrepreneur Center and participates in numerous other events geared towards making Nashville a nationally ranked location for starting a business.

You can read more about Alex here.

Comments

  1. I’m glad that you did a 12 part series to help startup businesses. A lot of people don’t realize how important mom and pop shops are. Without the support of them, we would be in a lot of trouble. Thanks again for helping the startups out! I learned a lot just from this 12 series blog!

  2. Interesting. Question, how many investors have your seen (or did it yourself) did not partake in additional rounds and allowed those shares to fall to another investor?

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