Preemptive rights are related to the ownership percentages of corporate entities like corporations and limited liability companies (“LLCs”) if and when said entity issues additional ownership/membership interests. Say, for example, that a member of an LLC currently has a 10% membership interest. For ease of math, assume 100 membership interests have been issued. If the LLC plans to issue an additional 100 membership interests, then, as can be seen, without preemptive rights, current members will see their percentage ownership diminish. This generally goes under the concept of dilution of ownership rights.
Legally, preemptive rights are contained in contractual agreements. In many LLCs, preemptive rights are set forth in the operating agreement (or other formation documents). Preemptive rights can also be contained in separate contractual agreements. The mechanism is generally simple. A preemptive rights agreement will give current members the option of obtaining a pro-rata share of any membership interests that are issued. Thus, for our example above, the member would be entitled to buy 10% of the newly issued membership interests. In this way, that particular member would maintain its 10% ownership interest. Preemptive rights may be limited to certain types of circumstances. For example, preemptive rights often exclude situations where additional membership interests are issued for incentive-based reasons — such as granting membership interests to well-performing employees.
When additional membership interests are issued, generally, a certain time frame — 30 to 90 days — is provided for current members to exercise their preemptive rights. This time frame will be set forth in the agreement. Failure to purchase the pro-rata share of newly issued membership interests will be deemed a waiver of preemptive rights.
If preemptive rights are deemed important to an owner/investor, due diligence is needed to ensure those rights are clearly stated in the operating agreement or in another agreement. Many states have statutory provisions negating preemptive rights unless stated in an agreement. See, for example, this provision in the Delaware Code:
“Unless otherwise provided in a limited liability company agreement or another agreement, a member shall have no preemptive right to subscribe to any additional issue of limited liability company interests or another interest in a limited liability company.” 6 Del. Code, § 18-305(e)
Preemptive rights are more common with LLCs than with corporations. This is because corporations generally issue different classes of stock, some of which allow for voting rights and other classes just entitle the shareholder to dividends and other types of profit sharing.
Preemptive rights are important for matters of control because certain corporate decisions will require approval from certain levels of the members. For example, the operating agreement may require a majority vote of the members for the purchase of real estate. Dilution of voting power can impact a member’s ability to exercise control over the company. Dilution of voting power may also negatively impact a member’s influence with respect to who is appointed as General Manager for the LLC. This is key since LLCs tend to grant their General Managers extensive control of the company. Obviously, dilution of membership interests also impacts expected profit distributions and any proceeds from an anticipated sale of the LLC.
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