Preemption vs Pro Rata?

As a novice angel investor, once you get to the stage where you start seeing term sheets you will often hear two similar sounding terms being banded about; ‘Preemption’ rights and ‘Pro-Rata’ rights.

The easiest way to explain is to ‘borrow’ paragraphs from the standard contract templates you find from SeedLegals, which is a great resource for first-time founders and investors.

Note: as a novice investor, we strongly suggest you consider investing using a crowd fund raising platform or SEIS fund until you get more experienced.

Back to topic. Once you invest in a start-up, if they are offering standard terms, you will be given preemption rights. These rights will cover the issuance of new shares and the sale of existing shares, so we need to explore both.

Preemption on New Issue of Shares

In this scenario and as covered elsewhere, as an existing shareholder, when new shares are issued, you have the preemption rights to take up a % of the new shares that will mean your % ownership of the company stays flat. This could mean you spending money to keep your ownership % flat with:

1. No increase in share price (flat round)

2. An increase in the value of your previous share purchase (up round)

3. A decrease in the value of your previous share purchase (down round). i.e. a distressed situation

So preemption is your right to not be left out of a round.

Pro-rata is your right to keep your shareholding % to previous levels.

The standard SeedLegals wording is as follows:

“All voting shareholders will have a right to participate in any new issue of securities in the Company (other than pursuant to the grant or exercise of options under the Option Pool) pro rata to their holding of shares.”

Last thing to be aware of is that in exceptional cases your preemption rights can be waived by the board. This is a very rare case and tied to very ‘hot rounds’, where the founders (and board seat carrying institutional investors) don’t want too much dilution to happen, so they will only allow enough new share issues and secondary share sales to satisfy what the new investors need and then vote at the board level to prevent any other smaller shareholders from exercising their preemption rights and forcing further dilution.

This leads to the interesting discussion topic of how to survive Series A onward funding rounds when your postion is small and you don’t have a board seat (to be written in the future).

On the plus side, in this scenario, as an exisitng shareholder you are generally allowed to sell your shares for the full value of the newly issued shares.

Preemption on Transfer of Shares

In this scenario, as an existing shareholder, when the board has agreed to allow a secondary share sale, you have first rights to buy a % of shares available, equal to the % of the company you currently own.

In a hot round, secondary shares are sold at the same price as the newly issued shares. In other scenarios, they will be sold at a discount, as the price you pay to get some cash out.

So in this case, preemption is your right to not be left out on the chance to buy the shares of other shareholders.

Pro-rata is your right to increase your shareholding in propotion to what % of shares you previously owned.

The standard SeedLegals wording is as follows:

“All shareholders, then the Company will have a pro rata right of first refusal to acquire any shares of the Company proposed to be transferred or sold.”

Note: Image generated using DeepAI with the text “preempting decisions”