If a company wants to raise additional equity or needs to accept a capital infusion, it must determine whether its existing equityholders have preemptive rights. Ignoring them always leads to curative diligence and paperwork, and sometimes can even cause line-item indemnities, litigation, and equity loss.

Preemptive rights give their holders the option to purchase a proportionate share of new equity before it is made available to other investors. This provides anti-dilution protection by allowing holders to, if they elect to do so, maintain their ownership levels.

If preemptive rights apply to an issuance, it is typical for a company issuing the new equity to first provide notice to those who hold the rights. The notice details the issuance and its terms. Holders can then decide whether they would like to participate. Offers usually have a defined timeframe (e.g., 5–30 days) before they expire, after which the company may proceed with the issuance taking into account anyone who elected to exercise their preemptive rights.

Holders who ignore or do not respond to the notice are typically considered to have waived or declined their preemptive rights, a default that makes upfront compliance all the more beneficial. If a company fails to send the notice in the first place, each holder’s signature will likely be required to retroactively bless the issuance. This can lead to costly negotiations and, at the very least, more paperwork.

Note some preemptive rights provisions permit companies to issue new equity first, then comply with the rights on the backend, if time is of the essence. After-the-fact compliance may be tempting, but it is not ideal. If anyone elects to exercise on the backend, the company will likely end up over-capitalized. There may be ways to structure around over-capitalization, but doing so often involves seeking waivers over transfer restrictions, may result in negative tax consequences, and sometimes requires compensation for interest or other applicable financing charges.

Whenever a company is issuing equity, whether in an extraordinary recapitalization or simply a routine capital infusion, confirm whether preemptive rights apply.

These principles may apply to debt securities as well.

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