In Israel, there are two types of preemptive rights. A preemptive right granted by the Companies Law (at the company’s discretion – it can be revoked in the company’s articles of association) and a contractual preemptive right granted to shareholders. The meaning of this right is that eligible shareholders have the ability to maintain their percentage of ownership in the company when it issues new securities.
Statutory Preemptive Right
In Israel, the Companies Law (Section 290) establishes a preemptive rights framework for companies. However, the section is dispositive (it can be overridden), meaning that its applicability can be revoked through a provision in the company’s articles of association, allowing for flexibility for the company and its management.
Contractual Preemptive Right
A contractual preemptive right is usually granted to investors in the context of a funding round. The rationale behind this is the ability to maintain their ownership percentage in the company. Naturally, when it comes to high-quality companies, investors generally seek to maintain their position, but this becomes particularly relevant when there are rights in the company that are dependent on maintaining a certain ownership percentage (to ensure eligibility for those rights). As we saw in another articles we've published discussion on rights tied to ownership of shares.
Below is an example of a classic preemptive right:
"Preemptive Rights. Each Major Shareholder shall have a right to purchase, each such Major Shareholder’s Pro-Rata Ratio, as of the date of the Rights Notice (as defined below), of any New Securities that the Company may, from time to time, propose to sell and issue. This right is subject to the following provisions:
If the Company proposes to issue New Securities, it shall give the Major Shareholders a written notice (the “Rights Notice”) of its intention, describing the New Securities, the price, the general terms upon which the Company proposes to issue the New Securities and the number of New Securities that each Major Shareholder has the right to purchase. Each of the Major Shareholders shall have fourteen (14) days from delivery of the Rights Notice to agree to purchase all or any part of such Major Shareholder’s Pro-Rata Ratio of such New Securities for the price and upon the general terms specified in the Rights Notice, by giving written notice to the Company setting forth the quantity of New Securities to be purchased.
The preemptive rights granted under this Article shall terminate upon an IPO and shall not apply to any New Securities that the Company may propose to sell and issue in the IPO.
Each Major Shareholder shall be entitled to waive such Major Shareholder’s preemptive rights described in this Article.
The provisions of Section 290(a) of the Companies Law shall not apply to the Company.”
Another element we sometimes see is the Over-Allotment Right, which grants major shareholders who exercised their right the ability to purchase the portion of any other major shareholder who did not exercise their right (within seven days). This type of provision has two aspects. A positive aspect, as its exercise demonstrates that there are "hungry" investors who seek to increase their share in the company. A negative aspect, due to the simple fact that this creates an opening for investors aiming to gain control of the company to increase their holdings, even if the company does not wish for this to happen. However, in such a situation, which is almost forced upon the company, the company retains significant bargaining power over the rights granted in connection with the exercise of the preemptive right (since the exercise will be made under the conditions offered to a new potential investor, which the company entirely controls).
Below is an example of this right:
"If any of the Major Shareholders fails to purchase their respective portion of the New Securities pursuant to the exercise of their preemptive rights within the period specified in this Article, then, the Major Shareholders that have agreed shall be offered to purchase any unpurchased New Securities under the Rights Notice and shall have seven (7) days to agree to purchase all or any part of its Pro-Rata Ratio of such New Securities. In the event that the Major Shareholders have failed to purchase the entire amount of New Securities offered under the Rights Notice, the Company shall have ninety (90) days after delivery of the Rights Notice to sell the unsold New Securities at a price and upon general terms no more favorable to the purchasers thereof than specified in the Rights Notice. If the Company did not sell the New Securities within said ninety (90) days period, the Company shall not thereafter issue or sell any New Securities without first offering such Securities to the Major Shareholders in the manner provided above.”
In the above provision, which is quoted from a company’s articles of association following a first investment round, we see a classic preemptive right granted to shareholders based on their ownership percentage (in this case, the eligible shareholders were the founders and the largest investor). The procedure is carried out so that when new securities are issued, the company will provide eligible shareholders with notice of the issuance, and they will have 14 days to notify whether they will exercise their right. If they do not, the company will have 90 days to offer the securities to third parties (new investors) on the same terms.
Additionally, at the end of the provision, the company also ensured to eliminate the statutory preemptive right provided under the Companies Law (by including a provision stating that Section 290(a) of the Companies Law does not apply).
Sometimes, this preemptive right is also important for investors who are not yet shareholders, when they invest in the company under convertible loan agreements, SAFE transactions (typically through a Side Letter), and Advanced Equity transactions.
A preemptive right has, in our view, a highly positive message, a company that maintains its investors as follow-on investors and gives them the opportunity to do so demonstrates a high level of confidence. Beyond that, this right creates early demand for the company’s securities even before the entrepreneur embarks on a roadshow among investors, making it easier for the entrepreneur to negotiate the company's valuation during fundraising, given the existing and inherent demand.
