What Are Preemptive Rights?
What Are Preemptive Rights?
What Are Preemptive Rights?
A U.S. company may give preemptive rights to all of its common shareholders.
but this is not required by federal law. If the company recognizes such rights, it
will be noted in the company charter. The shareholder also may receive a
subscription warrant entitling them to buy a number of shares of a new issue,
usually equal to their current percentage of ownership.1
KEY TAKEAWAYS
Preemptive rights in the U.S. are usually an incentive for early investors
and a way for them to offset some of the risks of the investment.
They are contract clauses that grant early investors the option to buy
additional shares in any new offering in an amount equal to their original
ownership stake.
Also called anti-dilution provisions, these rights guarantee that early
investors can maintain their clout as the company and its number of
outstanding shares grow.
Preemptive rights help early investors cut their losses if those new shares
are priced lower than the original shares they bought.
Common shareholders may be given preemptive rights. If so, this is noted
in the company charter and the shareholder should receive a subscription
warrant.
Understanding Preemptive Rights
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 use of preemptive rights in the U.S. is notably different from that of European
Union nations and Great Britain, where preemptive rights for purchasers of
common stock are required by law.2
This right is not routinely granted to shareholders in the U.S. Several states grant
preemptive rights as a matter of law but even these laws allow a company to
negate the right in its articles of incorporation.
The preemptive right cushions the investor's loss if a 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.
The preemptive right offers the shareholder an option but not an obligation to buy
additional shares of stock.
Since the shareholder is getting an insider's price for shares in the new issue,
there also can be a strong profit incentive.
In the worst case, there is the option of reducing losses by converting preferred
stock to more shares if the new issue is priced lower.
The savings in direct sales to existing shareholders lower the company's cost of
equity, and hence its cost of capital, increasing the firm's value.
Preemptive rights also are an additional incentive for a company to perform well
so it can issue a new round of stock at a higher price.
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 shares as necessary to protect that 10% equity
stake. In this example, that would be 50 shares if the prices of both issues were
the same.
The investor who exercises that right will maintain a 10% equity interest in the
company. The investor who opts not to exercise the preemptive right will still
have 10 shares, but they will represent less than 2% of the outstanding shares.
Preemptive Rights FAQs
Here are the answers to some commonly asked questions about preemptive
rights.
Great Britain and the European Union recognize the preemptive rights of
common shareholders. However, in the U.S., such rights are generally awarded
only to early investors and other insiders who have purchased shares or been
awarded options in companies that have yet to go public.4
They are used as an incentive to investment and a commitment that the holder of
preemptive rights will be able to retain voting rights at the same level as the
company grows.