What are Preemptive Rights?
Preemptive rights refers to the right available to the shareholder to maintain his/her ownership stake by giving them the chance to buy a proportional interest in any additional issuance of common stock in future. These are the rights granted to certain equity shareholders under which 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 shareholders ownership interest doesn’t get diluted even if company issue more shares.
- In short, the preemptive rights are important 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.
This is common provisions found in the shareholder’s agreement. The preemptive rights are important to shareholders because it is used to prevent new investors from reducing the existing ownership percentage of existing shareholders. It is pertinent to note here that having this right does not require an existing shareholder to purchase additional shares compulsorily. The shareholder can choose not to make use of this right and in such cases, the shares are sold to new investors and existing shareholders 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 important to shareholders because it grants the shareholders an opportunity but not an obligation to keep their initial ownership retained even when company goes for 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 fresh issue in proportion to their existing ownership, company can bring in new investors and resultant proportionate declines in their ownership).
- Another reason, these rights are important to shareholders because it protects investors from the risk of new shares being issued at a price lower than the price paid by previous investors. This is particularly more relevant in case of Convertible Preference shares.
Preemptive Rights Examples
Preemptive Rights Example #1 –
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 general public), this will clearly devalued 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) gets more share of common stock when he or she converts.
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, the these rights are important to shareholders because it incentivizes companies to perform well so they can issue stocks at higher valuation 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 own 100 shares of Anaya Corporation, thereby effectively holding 10% of the entire corporation. 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, this would dilute his ownership as follows:
- So K holding in Anaya Corporation declined from 10% to 5% in case of fresh issuance if these rights are not available.
- Now let’s assume that Preemptive rights are available to K and he exercised those rights by subscribing to the fresh issue in proportion to this existing ownership.
Types of Preemptive Rights
#1 – Weighted-Average
Under this existing shareholder is provided with the right to purchase shares at a price that takes into consideration the change in old price and new offered price.
#2 – Ratchet
Under this existing shareholder is provided with the right to buy shares at the new lower price.
Advantages of Preemptive Rights
- It becomes easy for a business to raise funds from existing early-stage investors, venture capitalist 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 in searching for new investors.
Disadvantages of Preemptive Rights
- It avoids the problem of concentration of ownership in few early stage investors only and allows business to exercise more control over business and limit the size of an individual investor’s ownership in the business
- It helps the company to negotiate better with new investors and command higher valuation for the business than with the existing investors.
- Many new investors intend to hold a significant ownership in the business and want a commitment from management for same. It becomes difficult to promise new investor that he/she will be able to acquire a certain percentage in cases where this right is being provided to early-stage investors as business is uncertain as to whether or not early investors intend to exercise their preemptive rights.
This has been a guide to what are Preemptive Rights? Here we discuss its types along with why preemptive rights are important for early investors. We also take preemptive rights examples, its advantages, and disadvantages. You may learn more about Private Equity and Venture Capital from the following articles –
- What is Private Equity?
- Limited Partners vs General Partners in Private equity
- Venture Capital
- Angel Investment vs Venture Capital