Preemptive rights, also known as subscription rights or first option to buy, are a type of privilege extended to existing shareholders of a company, allowing them to purchase additional shares in the company before new potential investors can.
When a company decides to issue new shares, existing shareholders may be concerned about dilution – the decrease in their ownership percentage in the company. Preemptive rights provide these shareholders with the opportunity to maintain their proportionate ownership by buying the newly issued shares before they are offered to the public or other new investors.
For example, if a shareholder owns 10% of a company’s shares and the company decides to issue new shares, that shareholder has the right to purchase 10% of the new shares before they are offered to others. This allows the shareholder to maintain their 10% ownership.
However, it’s important to note that preemptive rights are not universally provided. Whether or not shareholders have preemptive rights can depend on jurisdiction, the specific terms of the shares they own, and the company’s bylaws or articles of incorporation.
Example of a Preemptive Right
Imagine you own 100 shares in a company named ABC Corp., which has a total of 1,000 outstanding shares. Therefore, you own 10% (100/1,000) of the company.
Now, ABC Corp. decides to raise more capital and plans to issue an additional 500 shares. Without preemptive rights, if these new shares are issued, your ownership percentage would be diluted. Specifically, you would own less than 7% (100/1,500) of the company after the new shares are issued.
However, because you have preemptive rights, you are given the opportunity to maintain your ownership percentage. To do so, you have the right to buy 10% of the new shares (50 shares) before they are offered to the public. If you decide to exercise this right and purchase those 50 shares, you would then own 150 shares out of a total of 1,500, maintaining your 10% ownership in the company.
Preemptive rights, therefore, offer protection to existing shareholders from the dilution of their ownership stake when new shares are issued.