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Anatomy of a Term Sheet - Pre-emption

For more information on this post contact Scott Preece.

Pre-emption rights give Investors the right to acquire new shares issued by the Company to the extent necessary to maintain their percentage ownership in the Company. This is an important protection for investors as it allows them to protect their percentage ownership (albeit they have to pay). 

Under English law, the statutory default is that all shareholders have a right to maintain their percentage ownership in the Company (unlike some US States like Delaware where there is no statutory pre-emption), but these are frequently disapplied as the statutory provisions are not particularly flexible. When considering pre-emption you need to think about the following issues:

  • Who should get pre-emption rights? As stated above the statutory default in the UK, is that ALL shareholders get pre-emption rights. The statutory default is frequently replaced and companies can decide to limit who receives pre-emption. In US deals pre-emption is generally only given to investors only (and sometimes only to Major Investors (being Investors who hold more than X% of the Company)). This is generally negotiated, if you have taken SEIS/EIS money before a VC round your SEIS/EIS investors will typically demand to receive pre-emption rights. It should be noted that offering shares to all shareholders (if the strict process is followed) can have timing implications (as a formal offer is needed to go out to all shareholders).
  • How is the pro-rata calculated? You need to pay attention as to how the pro-rata is calculated - is this on a fully diluted basis (which is the most company favourable)? an as-issued basis (which is more dilutive and gives a shareholder the ability to increase their fully diluted ownership?)? or pro-rata to the number of preferred shares held (which is more dilutive again)?
  • Should investors receive over-allotment provisions or super pro-rata provisions? Over-allotment provisions allow an investor to purchase any shares not taken up by other shareholders. Such provisions can have timing implications as the offer then becomes a two-stage process. Super pro-rata provisions allow an investor to increase their ownership percentage to an agreed number. These provisions are not common, but when you do see them they can complicate fundraising.
  • Exceptions to pre-emption. Not all issues of shares should be subject to pre-emption. Most term sheets contain a list of customary exceptions (option issues, shares used for acquisitions, etc.), but this list should be reviewed to ensure that the company isn't inadvertently required to make a pre-emptive offer for a corporate transaction.

It should be noted that whilst pre-emption rights are important, very few investments follow the strict pre-emption provisions in the legal documentation (pro-rata entitlements tend to be negotiated before the legal documentation is finalised).

The Anatomy of a Term Sheet series can be found in full here

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