Pre-emption right

When the pre-emptive right is stipulated, the existing investors and share owners have the opportunity to keep their share of ownership during the capital raise and the next round of issuance of shares. This is done by subscribing new shares at or above the issue price.

The right of first refusal is an anti-dilution protection. A common provision in startup venture capital investments, where protection against dilution of ownership is used in most cases, but this is not necessarily a necessary part of the term sheet. 

If the investor has pre-emptive rights, he can buy the newly issued shares in proportion to his existing ownership before they go to the new, external investors. This form of anti-dilution protection is not typical for private investments, but rather when the company is looking for external investors in the wider market. This can be, for example, a public offering.

If the existing investor does not exercise his pre-emptive right, his share of ownership is diluted, i.e. his share in the company is reduced.

One of the characteristics of the right of first refusal is that it cannot be transferred, since in that case the investors could also trade with this right. At the same time, there may also be a case when the investor can buy newly issued shares in addition to the proportion of his existing share, still at a discounted price, i.e. at a price lower than the at the exchange rate of the issue.

Dilution can also occur if holders of share options (such as early employees, board members or other beneficiaries) exercise their options. If the number of shares increases, the share of each previous shareholder or investor decreases, meaning that each share is worth less. There may also be a case when the company receives extra cash during a merger, acquisition, or share exchange, which increases the value of the company proportionally, thus offsetting the dilution.