Preemptive rights are a fundamental right usually granted to current shareholders of a company to protect them from undesirable and involuntary dilution of their ownership stake. This right allows them the opportunity to purchase a proportional share of any future issuance of common stock to help maintain their original ownership percentage in the company.
Examples
Suppose ABC Company has 100 shares of stock outstanding, and you own 10 of these shares. This gives you a 10% stake. The board of directors decides to sell 100 additional shares in the company at $50 per share to raise capital for expansion. This would dilute your stake to 5% – 10 shares divided by 200 outstanding shares – if you do not have preemptive rights.
Impact of Preemptive Rights on You – Example
Now suppose ABC Company announces a major expansion and plans to issue 1,000 new shares of common stock in five years. You will only own 1.67% of the company when the new shares are issued – 20 shares owned divided by 1,200 outstanding shares – if you do not buy any new shares as part of your preemptive right.
Subsequent Offerings
This is referred to as a “subsequent offering” when the company issues shares after the initial public offering. There are two types of subsequent offerings: diluted and non-diluted. A diluted subsequent offering occurs when the company creates and offers new shares, causing existing shareholders to lose some of their ownership stake in the company. Non-diluted subsequent offerings consist of shares that are already present in the market.
Benefit to the Company
The main benefit of preemptive rights for most companies is that they provide them with capital. Companies must turn to an investment bank for coverage when they want to offer new shares to the general public, and this process is costly. It is much cheaper for the company to sell shares to existing shareholders instead of selling them to the general public.
Drawback for the Company
Some companies choose to waive preemptive rights because it can be inconvenient when they try to raise cash by issuing shares. Waiving preemptive rights also serves as a means to avoid some legal conflicts, such as oppressing minority shareholders. An example of this is when a company issues new shares at prices lower than what the shares are currently trading for, fully aware that minority shareholders will not be able to purchase the new shares as part of their preemptive right. A majority shareholder could take the opportunity to significantly increase their ownership stake while simultaneously reducing the stakes of minority shareholders.
Sources:
– U.S. Securities and Exchange Commission. “Form of Letter to Shareholders.”
– Washington State Legislature. “Shareholders’ Preemptive Rights.”
– Cornell Law School. “Preemptive Right.”
– Montana State Legislature. “35-1-535. Shareholders’ Preemptive Rights.”
Source: https://www.thebalancemoney.com/what-is-the-preemptive-right-358100
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