Reading: Protection and Participation

Preemptive rights allow the investors to buy shares pro rata if the company issues new shares in the future. For example, if a shareholder owns 5% of the firm's shares outstanding, he has the right to buy 5% of any subsequent round of financing. Therefore, these rights guarantee the investor that he can maintain his fractional ownership in the company.

In recent years, it has become increasingly popular for investors to receive the right to invest two times their pro rata ownership in the company. In the previous example, this would imply that the 5% shareholder has the right to buy 10% of any subsequent round of financing.

Discussion

Early stage investors can use all these rights and protections strategically to tilt the odds of financial success in their favor. 

It could make sense to participate in multiple promising ventures early on to get a foot in the door. In the successful portfolio companies, the VCs can then use their preemptive rights to keep investing and increase their financial exposure. At times when there is an abundance of capital in the industry waiting to be invested, such access to winning companies can be very valuable.

In the less successful companies, in turn, the VCs stop investing after the first round and thereby limit their financial loss. In addition, they might even benefit from anti-dilution clauses that protect their valuation against future down rounds.

By systematically increasing the exposure to winning companies and letting go of losing companies, VCs might indeed be able to tilt the odds of success in their favor.