What is a Preemptive Right
A preemptive right is a privilege that may be extended to certain shareholders of a corporation that grants them the right to purchase additional shares in the company prior to shares being made available for purchase by the general public in the event of a seasoned offering, which is a secondary issuing of stock shares. A preemptive right, also referred to as preemption rights, anti-dilution provisions, or subscription rights, is written into the contract between the stock purchaser and the company, although a few states grant preemptive rights as a matter of law unless specifically negated in a company's articles of incorporation. A preemptive right does not, however, function like a put option that gives a shareholder the right to sell back their stock at a specified price.
BREAKING DOWN Preemptive Right
When a majority shareholder of a company, or a shareholder committing large amounts of capital to a startup company, purchases stock shares, he often wants to ensure his ownership interest or voting power as a shareholder cannot be diminished or diluted by a secondary stock offering where the company issues a substantial amount of new shares with voting rights. By securing preemptive rights at the time of his initial stock purchase, the shareholder can make sure he is able to prevent any seasoned offering from diluting his ownership percentage.
The preemptive right grants the shareholder an opportunity, but does not confer an obligation, to buy an amount of shares prior to a seasoned offering that is proportionate to his existing equity ownership percentage - therefore it operates similarly to an option, although it is more like a right of first refusal. Here is a simple example: assume a company's initial stock offering consists of 100 shares, and an individual purchases 10 of the shares, giving him a 10 percent equity interest in the company. At a later point in time, the company makes a secondary (seasoned) offering of 500 additional shares. If the original shareholder holds a preemptive right, he must be granted the opportunity to purchase up to 50 shares of the new offering, which maintains his 10 percent equity interest in the company.
Types of Preemptive Rights
Preemptive rights may also be granted to purchasers of convertible preferred shares of a company's stock, since a seasoned offering of common stock diminishes the value of the preferred shares they hold in the event they elect to exercise their option to convert their preferred shares to common stock shares.
Preemptive rights may also be granted to a shareholder with either a ratchet-based provision or weighted-average provision that is applicable if a seasoned stock offering is issued at a lower price than the price of the shareholder's original shares. Under a ratchet provision, the shareholder is granted the right to buy additional shares at the lower price of the seasoned offering. A weighted-average provision grants a shareholder the right to buy additional shares at a price that accounts for the discrepancy in price between the original and the seasoned offering share prices.