Preemptive Rights in Venture Capital Financings - Considerations

An investor is asking for the guaranteed right to invest in future financings - these are some things you should consider.

Preemptive Rights provide investors the right to invest in future financings of the company. Investors want this right so they can maintain their pro rata ownership and follow their winners.

While that may seem reasonable, a founder should consider their future plans before extending these rights carte blanche.

First, consider if you want to be stuck with this investor. Once the investor has contractual preemptive rights, the company will need to extend the right to invest to that investor in any future financing. Situations, where this might not be ideal, would be if the investor is not a value add to the company or if it could jeopardize future financings.

How could preemptive rights jeopardize future financings? For starters, if the investor is a large shareholder, their preemptive rights could account for all or a majority of the shares ultimately being sold. This means that the company might be unable to bring on future strategic investors, either because there is no room or because the future investor is unwilling to invest less than a certain amount.

That said, extending Preemptive Rights in certain situations also makes sense. Often it is extended to investors that the company expects to be instrumental in the company’s growth, or as consideration for being a major investor, or for taking the initial risk of investing pre-rev, pre-product market fit, etc.

Preemptive Rights are often calculated based on the investor’s proportionate ownership of the company, in which case they are typically referred to as “Pro Rata Preemptive Rights.” For example, if the investor owns 20% of the company, they will have the right to invest up to 20% of the offering.

Alternatively, Preemptive Rights can also be “Super Preemptive Rights”, which in practice means Preemptive Rights that are not Pro Rata Preemptive Rights. Examples include the right to invest a certain $ amount in future financings (e.g., $1M) or the right to invest more than the investor’s pro rata share (e.g., 2x their pro rata share).

Further, these rights can be limited to only certain financings. For example, Y Combinator has prepared a form Pro Rata Side Letter, which is intended to be used in combination with a SAFE financing and which only provides the investor with Pro Rata Preemptive Rights in the financing in which the SAFE converts. This gives the company the ability to revisit Preemptive Rights in that future financing as opposed to being locked in in perpetuity.