Meaning
Capital increases achieved by distributing new corporate shares to selected investors rather than to all existing shareholders on an equal basis modify the ownership distribution of the entity. The execution of a non-pro-rata equity issuance alters both the voting power and the economic percentage of existing shareholders who are excluded from the transaction. This mechanism is frequently used during rescue financings or strategic corporate partnerships.
Dilution Effect
When a company issues shares only to a specific investor or a group of investors, the non-participating shareholders experience an immediate reduction in their ownership interest. In venture capital transactions, this structured distribution can occur during a down round where new investors demand a large equity stake as a condition of their investment. This process reduces the value of the existing holdings and reduces the voting power of early stage founders and angel investors.
To prevent this, early stage agreements usually include preemption rights that require the company to offer any new shares to existing investors first, but these rights can be waived by a majority vote of the designated share classes.
Protective Provision
Investment agreements often classify these capital increases as matters requiring special majority consent or class votes. These protective terms prevent the board or the majority shareholder from diluting the minority without their express agreement.
Board Discretion
Corporate directors must demonstrate that the decision to issue shares on an unequal basis serves the best interests of the company. If the company is facing insolvency, the board can justify the issuance as the only available method to secure necessary operational cash.
