When a company issues new shares, its articles of association typically require that the company first offers such shares to existing shareholders pro-rata to their shareholdings. This is called pre-emption.
The main purpose of pre-emption rights is to give existing shareholders a right to maintain their percentage interest in the company. There are typically carve-outs including the grant of options under the share option plan and shares issued for an acquisition. Crucially, these pre-emption rights can usually be dis-applied by a specified percentage or sub-group of the shareholders (for example, by a 'special resolution', which requires the holders of 75% to vote in favour).
Pre-emption rights are important for investors. They protect shareholders from being diluted out by other shareholders or new shareholders. Dilution of your percentage shareholding in a company will probably cause you less concern if the value of the company is increasing – each new issue of shares is at a progressively higher pre-money valuation so you have a smaller slice of a bigger cake. A good example of this principle is the mural artist, David Choe.
In 2005, David Choe was hired to paint some murals in Facebook HQ. He was offered a choice of two forms of payment: cash or Facebook stock. He took Facebook stock and despite being diluted in many subsequent fund raisings, ultimately the value of his stake at IPO was approximately $200m.
What about if the company is not growing?
If the value of the company is not increasing (or if it is increasing but you see the potential for even more growth in the future), being in control of whether or not to follow your first investment and continue to back the company can protect your investment and, ultimately, your share of the proceeds payable on any exit.
In the extreme, where the business has not performed, a company's management can decide to 'recapitalise' by raising funds at a price per share that is so low that the number of shares issued dwarfs the number of existing shares. In other words, the existing shareholders are 'washed out'. This is very rare, but it can happen.
What should I look for in investment documents?
The investment documents for some crowdfunding platforms contain pre-emption rights under which investors always have a right to subscribe for their pro rata share in any new share issue. In other words, there is no right for the company or other shareholders to set aside the pre-emption rights.
On the face of it, this is good news for investors. However, as an investor, you also need to be thinking about the company you have invested in and, in particular, whether it has the flexibility it needs to raise further rounds of finance from other investors in the future. If the terms of investment are not consistent with venture capital market norms, future venture capital investors – whose money may well be vital to taking the business from promising startup to global success – may be put off investing by the control given to a long tail of small crowdfunding investors.