Opinions on preemption rights differ. Some investors argue that they invest only one single time into any startup and then usually do not participate in follow-on rounds. Other investors use and oversubscribe their preemption rights. Below are my thoughts on the subject.
Some investors also argue that pre-emption rights are only interesting for large investors who, for example, hold a controlling stake in the startup (> 25%) and want to ensure that they keep it in subsequent rounds.
But first things first:
What are preemption rights?
Preemption rights are a right to participate in subsequent investment rounds of a startup. These pre-emption rights can therefore be granted to investors who have already invested into a startup in an earlier round. Typical are "pro rata" rights, which allow existing investors to keep their % share of the company constant in a subsequent round by making an additional investment. Keeping the percentage constant means counteracting the dilution caused by the newly issued shares of the new round.
Example on dilution and preemption:
An investor has invested EUR 10k in a seed round at a post-money valuation of EUR 1MM. So he owns 1% of the shares in this startup.
This firm is conducting its Series A investment round at a pre-money valuation of EUR3.4MM with a round size of EUR600k in new capital. This gives a post-money valuation of EUR 4MM. 600k of 4MM is newly issued shares. So the dilution is 15%. As a result, the investor now owns only 0.85% (1% * 0.85) of the shares in the startup unless they participate in the new round of funding.
Pro-rata pre-emption rights allow the investor to re-invest an amount of EUR 6k to acquire another 0.15% of the startup, so that he still owns 1% of the company's shares.
Pre-emption rights are always optional for the investor and never an obligation to invest further capital. In addition, professional investors/ VCs in particular sometimes require to take up the entire new financing round in order to secure a certain percentage of the startup. This can lead to an additional agreement being drawn up as part of the new round, which subsequently overrides the pre-emption rights of the existing investors. This agreement must be approved by a majority of the existing voting shares in order to be final. The waiver of the pre-emption rights will also be published on Companies House, so that it can be publicly reviewed.
Are preemption rights important?
In VC circles, the opinion is relatively clear: Always fight for pro rata rights. This option becomes particularly important when a startup is extremely successful. When a company valuation increases by a factor of 100x or more and a new unicorn/ decacorn (company with a valuation of > €1bn/ 10bn) is born, there is often so much interest that pro-rata rights can also be resold. Anyone who has found the next Uber or Tesla will certainly want to keep their percentage share in the company. In such a case, additional capital could be brought in by investor friends, as taking up your full pro rata rights may require significant capital in later rounds.
How often do you use preemption rights?
There is no general answer to this question. For each follow-on round, I will be looking at key figures and the company development. Future plans, new company valuation and startup multiples are recalculated. The achievement of goals and the performance of the past are also interesting in order to be able to draw conclusions about possible future performance.
A pre-emption round is special in one way: I already know the company! I am aware of how frequent and detailed the startup has provided investor reports. Regularly? On time and to the agreed extent? Including key figures or just marketing prose? How willing is the founding team to answer additional questions from investors? Regular follow-up rounds are particularly common in the UK. After 12-24 months there is often the chance to invest again.
Today, I rarely invest large amounts in a first round. Of course, this comes with risks: The valuation in the following round could already have "run away" if the company develops well. All in all, the advantages of increasing an investment only in a subsequent round outweigh the disadvantages for me. A founder who has reported well in the past will usually continue to do so. I can only evaluate a startup based on their financial performance and KPIs (hard facts). Missing, delayed or meaningless investor updates prevent a follow-on investment. Chances are that the identical lack of communication is also present internally at the startup. Potentially, the company doesn't have any substantial wins to report, as the venture isn't going well.
Larger follow-on investments in subsequent rounds are one option to increase your position in a potentially winning company. VCs sometimes allocate up to 65% of an entire fund for follow-on investments.
If I'm fully convinced that I've found a winner and/or a future unicorn, then I will try to use so-called "super pro rata" rights, i.e. not only keep my percentage share constant, but even increase it. This decision should always take into account the new startup valuation. I recently decided to massively expand my stake in the cargo e-bike company EAV (Electric Assisted Vehicles). Only existing investors could invest in this round. It sometimes pays off to own just a single share, as this can be the ticket to participation in a subsequent round. In the case mentioned above, the signs were just too good from my point of view: A future-oriented business model, a strong startup team, existing successes and pilot projects with large corporations as well as the entry of the Hong Kong-based VC H+ Partners, who have secured a 15% stake in EAV. The strategy of a single share as an entry ticket is risky, since a "super pro rata" participation (the expansion of one's own percentage share in the startup) is not guaranteed. In some cases, this means that Seedrs and the startup will limit your follow-on investment to your bare pro-rata rights, thus only allowing you to subscribe for a single additional share.
How do you handle follow-on rounds? Which additional aspects are important regarding preemption rights?