Preemptive rights refer to the right available to the shareholder to maintain their ownership stake by giving them the chance to buy a proportional interest in any additional issuance of common stock in the future.
These are the rights granted to certain equity shareholders. They are given the option to purchase additional shares of a company’s stock before the same is offered to any new investor. These are the rights available to existing shareholders to maintain their proportion of ownership of a company by acquiring the proportional share of additional stock issuances of the company, thereby ensuring that shareholder’s ownership interest doesn’t get diluted even if the company issues more shares.
Preemptive right is the opportunity given to the existing shareholders to subscribe to the newly issued shares of the company before it is open to the public. The shareholder preemptive rights are also known as Subscription rights, Anti-dilution rights, or Subscription privileges.
Investing in the initial stage of a company is a risky proposition. Early-stage investors would like to ensure that the risk they have taken should be rewarded with due returns once the company becomes successful.
These shareholder preemptive rights are necessary to shareholders because it grants the shareholders an opportunity but not an obligation to keep their initial ownership retained even when a company goes for an additional round of equity issuance by giving them the opportunity of the right of first refusal (i.e., only when the existing shareholders are not subscribing to the new issue in proportion to their existing ownership, the company can bring in new investors and resultant proportionate declines in their ownership.
It protects investors from the risk of new shares being issued at a price lower than the price paid by previous investors. It is rather more relevant in the case of Convertible Preference shares.
In short, it allows existing shareholders of a company to avoid involuntary dilution of their ownership stake by giving them the chance to buy a proportional interest in any future issuance of common stock.
It is a common provision found in the shareholder's agreement. The preemptive rights stocks are necessary to shareholders because they prevent new investors from reducing the existing ownership percentage of existing shareholders. It is pertinent to note that having this right does not require an existing shareholder to purchase additional shares compulsorily. The shareholder can choose not to use this right, and in such cases, the shares are sold to new investors, and the existing shareholder's proportion of ownership in the business declines.
Let's discuss the following types.
Under this, the existing shareholder is provided with the right to purchase shares at a price that considers the change in the old price and the new offered price.
Under this, existing shareholder is provided with the right to buy shares at the new lower price.
Let us understand the concept with some suitable examples.
Ray International issued convertible preferred stock to P at $15 per share convertible at the end of 2 years. It means P can convert the preferred stock into common stock by paying $15 each to Ray international after a specified period (2 years in this case). Ray International decided to go public and issued its equity shares at $12 per share to the general public. Now, if P converts his preferred stock into equity shares @ $15 each (against $12 per share offered to the general public), this will devalue the incentive to convert; however, if this right states that if Ray International issues shares at a price lower than in previous financing rounds, the preferred shareholder (in this case P) (in this case P) gets more share of common stock when they convert.
In such a scenario, these rights protected the interest of P from the risk of new shares being issued at a price lower than the previous issue. Also, these rights are necessary to shareholders because it incentivizes companies to perform well to issue stocks at higher valuations whenever the need arises.
Let's understand more with the help of one more example:
Anaya Corporation has 1000 shares of stock outstanding. K owns 100 shares of Anaya Corporation, thereby holding 10% of the entire corporation. The Board of Directors of Anaya Corporation decided to sell another 1000 shares of the corporation for $20 each. Now, if K is not provided with the preemptive rights stocks, this would dilute his ownership as follows:
| No of shares outstanding before fresh issue: 1000 shares |
| No of shares owned by K: 100 shares |
| K holding in Anaya Corporation: (100/1000)*100 = 10% |
| No of shares after the fresh issue of 1000 shares: 2000 shares (1000+1000) |
| No of shares owned by K: 100 shares |
| K holding in Anaya Corporation: (100/2000)*100 =5% |
| No of shares outstanding before fresh issue: 1000 shares |
| No of shares owned by K: 100 shares |
| K holding in Anaya Corporation: (100/1000)*100 = 10% |
| No of shares after the fresh issue of 1000 shares: 2000 shares (1000+1000) |
| No of shares additionally subscribed by K: 100 shares @ $20 each |
| K holding in Anaya Corporation after fresh issue: ,"answer":,"jsonQuestion":"Do preferred shareholders have preemptive rights?","jsonAnswer":"reemptive rights are typically given to preferred shareholders but may have some restrictions. These restrictions often include the rights of significant investors, who are granted the first opportunity to purchase shares before anyone else if they hold a certain amount or percentage of shares.">,,,]> --> |
reemptive rights are typically given to preferred shareholders but may have some restrictions. These restrictions often include the rights of significant investors, who are granted the first opportunity to purchase shares before anyone else if they hold a certain amount or percentage of shares.
Can preemptive rights be sold?Indeed, preemptive rights can be designed to enable early investors to purchase any unclaimed shares or equity units in subsequent investment rounds. It may allow an equity holder to raise their ownership percentage in the company pro rata.
Do all companies offer preemptive rights to shareholders?Not all companies provide preemptive rights to their shareholders. The decision to include preemptive rights in the company's corporate structure or the terms of new issuances is typically at the discretion of the company's management and board of directors.
Can shareholders waive preemptive rights?Yes, shareholders can waive their preemptive rights if they choose not to participate in the new issuance of shares. However, this decision would dilute their ownership percentage if new shares were issued to other investors.
This article has been a guide to what are Preemptive Rights. We explain its waiver along with examples, differences with right of first refusal & types. We also take preemptive rights examples, advantages, and disadvantages. You may learn more about Private Equity and Venture Capital from the following articles –
