Back in June, CrowdCheck opened up its "What due diligence looks like" series with a fundamental concept: checking whether offered shares of stock are "duly authorized, validly issued, fully paid and non-assessable." This is not just boilerplate language, but an actual legal requirement that gives investors confidence that they will be entitled to all the rights of stockholders to the full extent provided by the articles of incorporation and applicable corporations statues.
Digging a bit deeper, there is a specific element within this requirement that the prudent investor must establish—whether existing shareholders have preemptive rights and, if so, whether they have been properly waived.
Preemptive rights allow existing shareholders to maintain their current share of ownership if the company issues more stock to investors. They function like a right of first refusal: the existing shareholders have to buy the new shares the company intends to offer, but they get first dibs. Many state corporations statutes grant preemptive rights to existing shareholders. Additionally, early investors may demand preemptive rights in a contractual arrangement with the company. In either situation, the failure to satisfy or obtain a waiver of shareholders' preemptive rights might provide a basis for an issuance of shares to be voided and the issuer may not claim that the shares have been "validly issued."
The mechanics of failing to satisfy preemptive rights would go something like this:
Company X is offering common stock to investors through Funding Portal. Company X has already issued common stock to Seed Investor. Company X is incorporated in a state with a corporations statute that requires preemptive rights. Preemptive rights are not mentioned anywhere in Company X's articles of incorporation, term sheet, or subscription agreement. Company X has authorized 10,000,000 shares of common stock, and has issued 7,000,000, including 1,000,000 to Seed Investor. Company X issues 3,000,000 shares to new investors through Funding Portal. Now, Seed Investor has gone from 14% ownership to 10% ownership and is not happy. Seed Investor had preemptive rights to maintain 14% ownership, but the company does not have any more authorized shares to issue to Seed Investor. Seed Investor then initiates a proceeding and forces the reversal of the transaction in which Funding Portal investors purchased their shares. Now the new investors are upset.
Other situations where preemptive rights can gunk up the works for a new investor in a company is with convertible preferred shares. While corporations statutes preemptive rights requirements on common stock do not extend to preferred stock, an investor's exercise of conversion rights may be disallowed because there are not enough common shares available to satisfy existing preemptive rights.
Now that I have scared you with the consequences, I know you must be asking "oh my, this is terrible, how do I stop myself from falling into this trap where my investment could be involuntarily rescinded?" Well, the clear answer is due diligence.
Good due diligence will confirm whether or not the state of incorporation requires preemptive rights for existing shareholders or whether any existing agreements granted preemptive rights to previous investors. If neither condition applies, the company may represent that there are no preemptive rights, satisfying one of the conditions that deems shares to be validly issued. If preemptive rights are granted by statute, the company may waive those rights in its articles of incorporation. If it does not waive them in the articles, then the company must get every shareholder in the company to agree to waive preemption rights for the current offering.
The due diligence effort must look at prior financing rounds as well. The failure to properly waive preemptive rights in past financing rounds can negatively impact the current investment.
A prudent investor must have confidence that any necessary waivers of preemptive rights have taken place. CrowdCheck requests these documents from the company as part of its due diligence process and provides them to investors to help them make an informed investment decision. This effort also helps issuers from accidentally failing to meet the requirements of state law that could create legal concerns down the road.