NOTE: This is the twelfth post in our series about standard terms in early stage equity financings. These posts refer to the model Series A Term Sheet put out by the National Venture Capital Association (NVCA) and available for download here.
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As a preliminary matter, note that the “Right to Maintain Proportionate Ownership” is more commonly referred to as “Preemptive Rights” or the “Right of First Offer.” They are also sometimes referred to as the “Right of First Refusal,” though this term is more often used to refer to the right to purchase shares offered for resale by a stockholder (which we cover here).
Preemptive Rights give investors the first right to purchase shares offered for sale by the corporation in the future, subject to a few exceptions (typically the same as the exceptions to the Anti-dilution Provisions). There are three basic varieties of Preemptive Rights: (a) each investor is entitled to purchase just that portion of the offered shares necessary to allow her to maintain her percentage ownership of the company (i.e. if the investor owns 10% of the company before the offering, she would be entitled to purchase 10% of the shares offered), (b) each investor may purchase some multiple of her pro rata portion (i.e., if a 2X right, an investor owning 10% of the company before the offering would be entitled to purchase 20% of the shares offered) or (c) the investors, collectively, are entitled purchase all of the shares offered by the corporation and each investor is entitled to purchase her pro rata portion of the total based on ownership relative to other investors with Preemptive Rights. In all three varieties, investors may also have the right to purchase a pro rata portion of any shares not subscribed for by other investors with Preemptive Rights (this is called an Over-allotment or Over-subscription Right).
Preemptive Rights are standard in Series A deals, but it is generally in the company’s interest to limit their scope so it has greater flexibility to raise money from outside investors. Ideally this means only giving investors the right to maintain their pro rata ownership in the company, though an Over-allotment Right is often granted, as in the NVCA term sheet, so the investors as a whole have the opportunity to maintain their pro rata ownership even if not all investors elect to participate. Another way Preemptive Rights are sometimes limited is by only granting them to “Major” investors, usually being venture capitalists and large angel investors. Note that limiting the scope of the Preemptive Rights is considerably less important where the investors are subject to a Pay-to-Pay. Where there is no Pay-to-Play, the company (and sometimes the lead investors) may still try to include a “use it or lose it” provision so that investors who do not fully exercise their Preemptive Rights lose them for future rounds.