What Are Preemptive Rights?
Preemptive rights are a contractual clause giving a shareholder the right to buy additional shares in any future issue of the company's common stock before the shares are available to the general public. Shareholders who have such a clause are generally early investors or majority owners who want to maintain the size of their stake in the company when and if additional shares are offered.
A preemptive right is sometimes called an "anti-dilution provision." It gives the investor the option of maintaining a certain percentage of ownership of the company as it grows.
- A preemptive right allows an early investor to maintain voting clout in a company even if new shares are issued.
- The right can also protect the early investor from a loss if the new shares are priced lower than the initial shares.
- Preemptive rights are routinely offered only to early investors and majority shareholders, not to all shareholders.
In addition, the preemptive right may protect the investor from a loss if the new round of common stock is issued at a lower price than the preferred stock owned by the investor. In this case, the owner of preferred stock has the right to convert the shares to a larger number of common shares, offsetting the loss in share value.
Understanding the Preemptive Right
The preemptive right clause is commonly used as an incentive to early investors in return for the risk taken in financing a new venture.
This right is not routinely granted to all shareholders. Several states grant preemptive rights as a matter of law but even these laws give the company the ability to negate that right in its articles of incorporation.
A preemptive right is essentially a right of first refusal. The shareholder may exercise the option to buy additional shares but is under no obligation to do so.
The Benefit to Shareholders
Preemptive rights protect a shareholder from losing voting power as more shares are issued and the company's ownership becomes diluted.
Since the shareholder is getting an insider's price for shares in the new issue, there also can be a strong profit incentive.
At the very least, there is the option of converting preferred stock to more shares if the new issue is priced lower.
The Benefit to Companies
It is less expensive for a company to sell shares to current shareholders in a new offering than to sell shares to the general public, as the company would not need to pay for investment banking services.
These savings would lower the company's cost of equity, and hence its cost of capital, increasing the firm's value.
Preemptive rights also are an incentive for companies to perform well so they can issue a new round of stock at a higher valuation when necessary.
The preemptive right offers the shareholder an option but not an obligation to buy additional shares of stock.
Example of Preemptive Rights
Let's assume that a company's initial public offering (IPO) consists of 100 shares and an individual purchases 10 of the shares. That's a 10% equity interest in the company.
Down the road, the company makes a secondary offering of 500 additional shares. The shareholder who holds a preemptive right must be given the opportunity to purchase as many as 50 shares, or 10%, of the new offering. The investor can exercise that right and maintain a 10% equity interest in the company.
If the investor decides not to exercise the preemptive right, the company will sell the shares to other parties and the early shareholder's ownership percentage in the business will decline.