What are Preemptive Rights?

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 shareholdersEquity ShareholdersShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders’ Equity Statement on the balance sheet details the change in the value of shareholder’s equity from the beginning to the end of an accounting period.read more. 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.

  • In short, the preemptive rights are necessary to shareholders because 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.Preemptive rights are also known as Subscription rights, Anti-dilution rights, or Subscription privileges.

It is a common provision found in the shareholder’s agreement. The preemptive rights 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.

Why are Preemptive Rights Important?

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 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).Another reason, these rights are necessary to shareholders is that it protects investors from the risk of new shares being issuedShares Being IssuedShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner’s equity on the Company’s balance sheet.read more at a price lower than the price paid by previous investors. It is rather more relevant in the case of Convertible Preference shares.

Preemptive Rights Examples

Preemptive Rights Example #1 –

Ray International issued convertible preferred stockConvertible Preferred StockConvertible preferred stocks are a special class of stocks which give the right to convert its preferred stock holding into fixed numbers of shares of company’s common stock after the predetermined period. These are hybrid instruments with fixed dividends, providing options to acquire common stock.read more 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 shareholderPreferred ShareholderA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation.read more (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.

Preemptive Rights Example #2 –

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 DirectorsBoard Of DirectorsBoard of Directors (BOD) refers to a corporate body comprising a group of elected people who represent the interest of a company’s stockholders. The board forms the top layer of the hierarchy and focuses on ensuring that the company efficiently achieves its goals. read more 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, this would dilute his ownership as follows:

  • So K holding in Anaya Corporation declined from 10% to 5% in case new issuance of these rights is not available.Now let’s assume that Preemptive rights are available to K, and he exercised those rights by subscribing to the new issue in proportion to this existing ownership.

Types of Preemptive Rights

Let’s discuss the following types.

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#1 – Weighted-Average

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.

#2 – Ratchet

Under this, existing shareholder is provided with the right to buy sharesBuy SharesKnowing how to buy shares is crucial for a person who wants exposure to the equity market. Equity markets are volatile, and timing is very important. Shares trade in exchanges, but you just can’t go and buy a share from the exchange. There are several steps involved in purchasing a share.read more at the new lower price.

Advantages of Preemptive Rights

  • It becomes easy for a business to raise funds from existing early-stage investors and venture capitalists as they are already familiar with the company. It avoids the cost of due diligence, time delays, and excessive negotiation with new investors. If existing investors are providing additional funding, it saves the management time searching for new investors.

Disadvantages of Preemptive Rights

  • It avoids the concentration of ownership in a few early-stage investors only. It allows a business to exercise more control over the business and limits the size of an individual investor’s ownership of the business.It helps the company negotiate better with new investors and command a higher valuation for the business than with the existing investors.Many new investors intend to hold significant ownership in the business and want a commitment from management. It becomes challenging to promise a new investor that they will be able to acquire a certain percentage in cases where this right is being provided to early-stage investors as a business is uncertain as to whether or not early investors intend to exercise their preemptive rights.

Preemptive Rights Video

This article has been a guide to what are Preemptive Rights? Here we discuss its types and why preemptive rights are essential for early investors. We also take preemptive rights examples, advantages, and disadvantages. You may learn more about Private Equity and Venture Capital from the following articles –

  • Redeemable Preference SharesDrag-Along RightsWhat are Voting Shares?Angel Investment vs. Venture CapitalPrivate Equity in Brazil