Preference rights are rights granted to holders of preference shares that give these shareholders preferred treatment or priority over common shareholders on some issues in the business entity.
1. Pre-emptive Rights:
Pre-emptive rights are rights given to preferred shareholders of a company to purchase additional shares in the event the company issues additional shares in the future, so they can maintain the same percentage of ownership in the company and avoid diluting their ownership percentage.
Venture capitalists, early investors, and other investors typically want to preserve their ownership percentage in startups they believe have high potential. In the US, some states, such as Washington, statutorily provide for pre-emptive shareholder rights.
2. Right of First Refusal:
The right of first refusal gives investors a choice to buy shares from the company before the shares are offered to a third party. This protects investors’ interests and helps them maintain control of their share percentage in the startup. It also gives them a say in who gets onto the cap table.
When a common shareholder receives an offer for their shares from a third party, the common shareholder is obligated to present the terms of the request to all investors with the right of first refusal. The investors must respond to the offer within a certain period. If they elect to purchase the shares, the common shareholder must accept the investors’ request over the third party. Note that investors are not obligated to buy the shares when offered; they have the option to either purchase or refuse.
3. Drag Along:
A drag-along right enables a majority shareholder to force a minority shareholder to participate in the sale of a company to a third party. But the minority shareholders still receive an equal sales price, terms, and conditions as the majority shareholders. In venture capital cases, minority shareholders are typically the founders, but this generally depends on the startup stage.
However, where the minority shareholders vote in favor of the sale in a drag-along situation, they forfeit their appraisal rights—the right of a minority shareholder to petition the court for a fair value of their shares.
Drag-along rights are usually written on a term sheet. Investors usually exercise their right to droop during a startup sale or a merger with another entity, as it facilitates sales between companies. Investors include this right to avoid a situation whereby an attractive offer is made to acquire a startup, and the minority shareholders don’t want to sell.
4. Tag-along:
Tag-along rights are also called co-sale rights. Where a majority shareholder sells their stake, the tag-along right gives the minority shareholder the right to sell their minority stake in the company and participate in the sale. On the one hand, the majority shareholder must include the minority shareholder in the negotiation. The minority shareholder, on the other hand, may either agree to sell their stake or decline.
Where the minority shareholders exercise this right, their shares are purchased at the same price and conditions as the majority shareholders. Tag-along rights serve to protect the minority shareholders in a startup.
5. Pro-rata Rights:
Pro-rata rights give investors the right to participate in one or more future rounds of financing. These rights allow investors to maintain their ownership stake in a startup as it grows to avoid dilution when new investments are made. The investors are not obliged to exercise the right; they have the option of participating or declining.
When a company starts to do well, it becomes more attractive to other investors, and it may become more challenging to get an allocation to the company. Existing investors’ rights guarantee existing investors’ allocation if they want to invest.
For companies where maintaining a particular percentage ownership stake is required to keep a board seat, pro rata rights help investors hold their board positions. Typically, pro-rata rights are granted to significant investors in rounds.
Generally, founders should exercise discretion when offering pro-rata rights because it is possible that a single prominent investor or a small group of investors could significantly build their ownership stake through progressive rounds of funding and effectively take control of the company because the founders have been considerably diluted.
6. Anti-dilution Rights:
Anti-dilution rights give investors the right to maintain ownership percentages and protect them from dilution if new shares are issued. Where new shares are issued, the total number of shares outstanding will increase while the investor still owns the same number.
The new shares may be issued lower, causing the investors’ shares to lose value. This is because when a company raises money at a lower valuation than in the previous fundraising round (i.e., a down-round), the dilution experienced by early investors is more significant than it would be if the company had raised at a higher valuation, reducing both their ownership stake and equity value.
The anti-dilution provision works by automatically tweaking the rate at which preferred stock converts to common stock—it increases the number of common shares each preferred share converts to in a capital raise.
Anti-dilution provisions are standard in venture capital funding.