Pre-emptive Rights

What are pre-emptive rights?

Pre-emptive rights (German: Bezugsrechte) describe the right of existing shareholders to take up new shares in a capital increase in proportion to their existing holding before third parties are considered. A shareholder who exercises the pre-emptive right and pays for the new shares keeps their percentage stake despite the issue of new shares. The spelling preemptive rights is equivalent.

Pre-emptive rights apply to every capital increase, that is, every issue of new shares against a contribution, but especially to funding rounds. For the Aktiengesellschaft (AG, German stock corporation), the law regulates them expressly. The German Limited Liability Companies Act (GmbH-Gesetz, GmbHG) contains no such provision, so for a GmbH (German limited liability company) they are structured in the articles of association and the shareholders' agreement (the contract between the shareholders alongside the articles). Investors negotiate them as a claim to participate proportionately in later rounds, often called a pro rata right in the market. With them they control how strongly their holding is diluted by new rounds (Dilution).

Legal framework in Germany

Stock corporation: Section 186 AktG

In an AG, each shareholder must, on request, be allotted a portion of the new shares corresponding to their share of the previous share capital (Grundkapital) (Section 186(1) of the German Stock Corporation Act, Aktiengesetz, AktG). A period of at least two weeks must be set for exercise. For listed companies, a capital increase with pre-emptive rights is called a rights issue (Bezugsrechtsemission); there the pre-emptive right itself is often traded on the stock exchange during the subscription period.

The pre-emptive right can be excluded only in the resolution on the capital increase, by a majority of at least three quarters of the share capital represented. The exclusion must be announced expressly in advance, and the management board must set out its reason in a written report (Section 186(3) and (4) AktG). According to case law, the exclusion must also be objectively justified, that is, be in the interest of the company and be proportionate. For listed companies, the law makes it easier to exclude pre-emptive rights to a limited extent for cash capital increases if the issue price is not significantly below the stock market price.

GmbH: no express statutory provision

The GmbHG contains no provision on pre-emptive rights. The prevailing view in case law and the specialist literature nevertheless recognises them. It bases them on an analogous application of Section 186 AktG or on the duty of loyalty (Treuepflicht) and the principle of equal treatment of shareholders. An exclusion then requires, in addition to the majority of three quarters of the votes cast that is needed for the capital increase anyway (Section 53(2) GmbHG), an objective justification. Because scope and limits are not laid down by statute, the articles of association and the shareholders' agreement regulate the pre-emptive right expressly.

Technically, in the capital increase resolution the company admits certain persons to take up the new shares (Section 55(2) GmbHG). The declaration of acceptance requires notarial recording or certification (Section 55(1) GmbHG). In a funding round, the resolution usually admits only the new investor and those existing shareholders who subscribe alongside. All the others waive their pre-emptive right in the participation agreement or in the capital increase resolution so that the resolution cannot be challenged.

Contractual pre-emptive rights in the shareholders' agreement

Content and basis of calculation

The contractual pro rata right gives investors the claim to participate in future capital increases in proportion to their holding. The basis of calculation must be regulated: the issued share capital or the fully diluted holding (Fully Diluted) including options and conversion rights. Because the company can issue new shares only by shareholders' resolution, the shareholders at the same time undertake to vote so that the entitled parties are admitted to take up shares.

Formula: pre-emptive shares = existing percentage stake × number of new shares

Exceptions are customary for shares issued for employee participation and for the conversion of convertible loans. Also excepted are shares arising from anti-dilution protection and issues to strategic partners approved by the investor majority.

Major investors, over-subscription and extended rights

The contractual pre-emptive right often belongs only to major investors. In German agreements, the threshold is usually determined by a minimum percentage stake or a minimum investment amount. An over-subscription right is common: if individual entitled parties do not use their right, the others can take up the shares that become free. An extended pre-emptive right beyond one's own stake (super pro rata) is rare. It is viewed critically because it reduces the room for a new lead investor, that is, the investor who leads a round and negotiates its terms to a decisive extent.

Some agreements link the pre-emptive right to disadvantages in case of non-exercise. Under a pay-to-play rule, an investor who does not participate in a follow-on round loses, for example, preferential rights or anti-dilution protection.

Pre-emptive rights in funding rounds and due diligence

A new lead investor generally aims for a certain target stake. If existing investors exercise their pre-emptive right, less remains for the lead investor. The round must then be enlarged, or existing investors partly waive. In practice this allocation is negotiated early, often even before the term sheet. New investors also pay attention to whether the existing investors subscribe a follow-on investment and ask questions if they do not follow despite having a pre-emptive right.

In due diligence, investors and acquirers check whether earlier capital increases were validly resolved and registered and whether existing pre-emptive rights were respected or disposed of by waiver. If waiver declarations are missing, a risk arises for the validity of earlier resolutions and thus for the cap table, the overview of all shareholders and their shares.

Worked example: calculating a pre-emptive right in a funding round

An investor holds 10,000 of 100,000 shares of a GmbH, that is, 10%. In a funding round, 25,000 new shares with a nominal amount of EUR 1 each are issued at a price of EUR 100 per share. The investor has a proportionate pre-emptive right based on the issued share capital.

• Share capital after the round: 100,000 + 25,000 = 125,000 shares.
• Without participation: 10,000 / 125,000 = 8% stake.
• Pre-emptive right: 10% × 25,000 = 2,500 new shares at 2,500 × EUR 100 = EUR 250,000. Of this, EUR 2,500 goes to the share capital and EUR 247,500 as premium above the nominal amount to the capital reserves.
• With participation: (10,000 + 2,500) / 125,000 = 12,500 / 125,000 = 10% stake.
• For the new lead investor, 25,000 minus 2,500 = 22,500 shares remain, that is, 22,500 / 125,000 = 18% instead of the 20% it would have received without the pre-emptive right.
• Enlarged round: if the lead investor insists on 20% and the existing investor subscribes in full, the lead investor receives 90% of the new shares N. From 0.9 × N = 20% × (100,000 + N) it follows that N = 20,000 / 0.7 = around 28,571, rounded 28,600 new shares. Of these, the existing investor receives 10% = 2,860 and the lead investor 25,740 shares, that is, 25,740 / 128,600 = around 20%. The round volume rises from EUR 2.5 million to EUR 2.86 million.

The pre-emptive right secures the existing investor's 10% but reduces the share that remains for new investors. The alternative to the larger round is a partial waiver by the existing investor. Existing and new investors regularly negotiate this distribution in follow-on rounds.

Distinctions: pre-emptive right, right of first refusal and anti-dilution protection

• Anti-dilution protection: compensates for value dilution in a round at a lower price through additional shares or a price adjustment. The pre-emptive right protects only the stake and only against payment of the full price.
• Right of first refusal (Vorerwerbsrecht): relates to existing shares that a shareholder wants to sell. The pre-emptive right concerns new shares from a capital increase. Both rights often appear together in the shareholders' agreement, as described for the Co-Sale Agreement.
• Pay-to-play: attaches disadvantages to non-exercise of the pre-emptive right. The pre-emptive right itself is a right, not an obligation.
• Follow-on investment: the actual participation in a later round. The pre-emptive right secures access to it.

Common mistakes

• No voting obligation. A contractual pre-emptive right without an obligation of the shareholders to admit the entitled parties to take up shares can be bypassed in the resolution.
• Unclear basis of calculation. Whether the stake refers to the issued share capital or to the fully diluted holding changes the number of pre-emptive shares.
• Missing exceptions. Without an exception for employee participation and conversions, each of these issues triggers a pre-emption procedure.
• Extended pre-emptive rights for early investors. A right beyond one's own stake can deter later lead investors.
• Undocumented waivers. If written waiver declarations from earlier rounds are missing, due diligence calls the validity of the resolutions into question.

Frequently asked questions

Do shareholders of a GmbH have a statutory pre-emptive right?

Not expressly. The GmbHG does not regulate it, but the prevailing view recognises it by analogous application of stock corporation law. Participation agreements and shareholders' agreements therefore regulate it expressly; it is implemented in the specific resolution by admission or waiver.

What is the difference between pre-emptive rights and right of first refusal?

Pre-emptive rights apply to new shares from a capital increase, the right of first refusal to existing shares that a shareholder wants to sell to third parties. The pre-emptive right protects one's own stake from dilution. The right of first refusal keeps unwanted acquirers out of the company, because the fellow shareholders can buy the shares first themselves.

Is an investor obliged to exercise its pre-emptive right?

No. The pre-emptive right is a right. Only if the agreement contains a pay-to-play rule does non-exercise have economic consequences.

Do holders of convertible loans have a pre-emptive right?

As a rule, no. Before conversion they are creditors, not shareholders. A right to participate in later rounds arises only after conversion or through a separate agreement.

Can the pre-emptive right be excluded in a GmbH?

Yes. A majority of three quarters of the votes cast and an objective justification are required. In funding rounds, instead of a contested exclusion, a waiver by all non-subscribing shareholders is usually agreed.

Does the pre-emptive right also apply to shares for employee participation?

Mostly not. Shareholders' agreements expressly exclude shares for employee participation. With virtual programmes, no new shares arise in the first place.

The Roemer Capital view

When planning a funding round, Roemer Capital calculates early how many shares existing investors can claim through their pre-emptive rights and how much remains for a new lead investor. From this it follows whether the round size must be adjusted. Roemer Capital asks the existing investors about their willingness to participate before talks with new investors begin, because their commitment or refusal shapes the negotiation.

The company's law firm implements the capital increase resolution, admission and waiver declarations. Roemer Capital ensures that the figures for this are consistent across the participation agreement, the resolution and the cap table.