Preemptive Right

A preemptive right offers select shareholders of a corporation the right to buy a proportional interest in any future issue of the company's common stock. In the event of a follow-on offering—also called secondary offering, seasoned offering, or seasoned issue—shareholders with preemptive rights have the opportunity to buy newly issued shares in the company prior to the shares being offered to the general public.

Although preemptive rights offer the opportunity to buy stock, they do not infer any kind of obligation to buy stock on the part of a shareholder. In this way, they are like a right of first refusal.

Preemptive rights are not necessarily granted to all shareholders; usually, they're offered only to majority shareholders or early-round investors. Preemptive rights—also called preemption rights, anti-dilution provisions, or subscription rights—are written into the contract between the investor and issuer. A few states, however, grant preemptive rights as a matter of law unless specifically negated in a company's articles of incorporation.

Important for Shareholders

Preemptive rights can prevent a shareholder's percentage of equity ownership, along with his voting power, from becoming diluted by new investors buying stock in the company. Current shareholders who have preemptive rights may purchase new shares in a seasoned offering in proportion to their existing of equity-ownership percentage. Preemptive rights also protect an investor from the risk of new shares being issued at a lower price than what he paid originally.

Equally Beneficial to Corporations

It may be less expensive for a company to issue new shares to current shareholders in a seasoned offering than to sell shares to new investors, as the company would not need investment banking services. These savings would lower the company's cost of equity, and hence its cost of capital, increasing the firm's value. Preemptive rights also are an incentive for companies to perform well so they can issue stock at higher valuations when necessary.

[Important: A preemptive right offers the right to buy—but not an obligation to buy—new-issue stock.]

As a simple example, let's assume that a company's initial public offering (IPO) consists of 100 shares and an individual purchases 10 of the shares, giving him a 10% equity interest in the company. Sometime later, the company makes a secondary offering of 500 additional shares. If the original shareholder holds a preemptive right, he must be given the chance to purchase as many as 50 shares (10%) of the new offering. Assuming the investor exercises his preemptive right, he would maintain his 10% equity interest in the company.

However, what if the investor chose not to exercise his preemptive right? In that case, the company would sell the shares to other parties and the existing shareholder's ownership percentage in the business would decline.