How best to use pre-emptive rights in LLC agreements is an important consideration in drafting partnership agreements. A pre-emptive right is a way to protect your LLC interest against dilution. Not all LLC agreements contain these rights, and if you are a minority owner or investor, you must pay close attention to ways in which your interest can be negatively impacted by the actions of the majority owners.
A pre-emptive right gives the member the right to buy a pro rata portion (i.e. a portion based on the member’s respective ownership interest in the company) of any new membership interests issued by the company. This right prevents the company from diluting the existing member’s ownership interest.
Why Should You Care?
Because LLC agreements contain many provisions that are based on ownership percentages. For example, an LLC agreement might contain a provision that the manager can’t invest more than $50,000 of the LLCs capital without the approval of 81% of the members. If you’re a minority investor owning a 20% stake, this means that you must give your approval for such an investment to be made. What would happen if the LLC were to issue new units? Your interest would be diluted and your veto power would disappear.
The creation of additional membership units would impact profit and loss allocations, voting rights, management rights, dissolution rights, possible audit rights, and all rights based on ownership interests.
Sample language creating a pre-emptive right might read something like this:
Pre-emptive Right. The company hereby grants each member the right to purchase its pro rata portion of any new membership interest that the company may from time to time propose to issue or sell to any party. The company shall give written notice of any proposed issuance or sale to the members within three (3) business days following any decision by the manager to issue new membership interests. If any offer has been made, the notice shall be accompanied by such written offer from any prospective purchaser seeking to purchase such units and shall set forth the material terms of the proposed purchase, including the number of units being purchased, the price being paid, and the date by which such sale must be finalized. Within thirty (30) days following such notice, each member may elect to purchase its pro rata portion of the units being issued at the price set forth in the notice.
As you see in this language, the pre-emptive right does not guarantee that the member’s interest won’t be diluted. The pre-emptive right gives that member the option to buy additional units to preserve that member’s overall interest in the LLC. The exact wording of the pre-emptive right will change depending on the relative negotiating strength of the parties. Also, the agreement might provide that certain classes of members have pre-emptive rights, while other classes do not. Don’t assume that all members are treated equally.
To better understand whether a pre-emptive right should be part of your LLC operating agreement, consult with an attorney experienced in drafting such agreements.