What are preemptive rights?
Why is it so important for companies and shareholders to know about it?
How does it actually work?
In this article, we will break down the notion of “preemptive rights” so you know all there is to know about it.
We will look at what are preemptive rights, its definition, why it’s important for investors, compare it to the right of first refusal and anti-dilution rights, look at a concrete example, see how a preemption right clause is drafted in a contract and more.
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What are preemptive rights
Preemptive rights (also known as anti-dilution rights or a first option to buy rights) are rights given to shareholders of a company to purchase additional shares in the event the company issues additional shares in the future so they can maintain the same percentage ownership in the company preserving value and voting rights.
In other words, before a company can issue shares of stock (typically common shares) to the public or third parties, the shareholders having preemptive rights can purchase a certain number of shares to avoid having their ownership percentage diluted.
Having preemptive rights does not obligate a shareholder to buy shares every time a company issues additional shares to the public.
Rather, the shareholder has the option or choice to purchase additional shares in the future.
Best Corporation Inc has issued 1,000 shares to 5 shareholders (each having 200 shares) giving each shareholder 20% stock ownership.
If the company were to issue another 1,000 shares to new investors, without preemptive rights, the current shareholders’ stock ownership percentage will dilute to 10% (200 shares over 2,000 shares).
With preemptive rights, the shareholders have the option to purchase 200 additional shares out of the 1,000 new securities issued so they can maintain their 20% stake in the business.
For the shareholders having preemptive rights, it’s as if they have the right of first refusal when the company issues new shares.
Typically, venture capitalists and investors who invest early on in the company’s life will want to preserve their percentage ownership if they believe the company is doing well or can do well in the future.
Early investors take greater risk than future investors not knowing if the company may eventually do well in the future.
As an incentive, early investors are granted preemptive rights and anti-dilution rights to ensure that they can maintain their percentage ownership in future financing rounds when common stocks are issued.
Articles of Incorporation
For shareholders to have preemptive rights, the company must provide for a preemptive clause in its articles of incorporation.
Without an express preemptive rights clause, the shareholders will not have the ability to benefit from such a right.
For example, in the state of Washington, RCW 23B.06.300 states:
(1) The shareholders of a corporation do not have a preemptive right to acquire the corporation’s unissued shares except to the extent the articles of incorporation provide otherwise or as set forth in subsection (2) of this section.
Statutory preemptive rights
However, some states provide for shareholder preemptive rights by operation of law.
In such cases, to maintain the shareholder preemptive rights, the company does not necessarily need to include anything in its articles.
On the flip side, a company can choose to include a waiver of preemptive rights in their articles of incorporation to override the application of the law expressly.
For example, again, in the state of Washington, RCW 23B.06.300 states:
(2) Unless the articles of incorporation provide otherwise, the shareholders of a corporation formed before January 1, 2020, have a preemptive right to acquire the corporation’s unissued shares.
Types of preemptive rights
There are two types of preemptive rights:
- Weighted-average preemptive right (ability to buy new shares a lower price)
- Ratchet-based preemptive right (ability to buy new shares taking into account the price paid for previous shares and the price of the new shares)
Preemptive rights definition
What is the legal definition of preemptive rights?
According to the Cornell Law School’s Legal Information Institute, preemptive right is defined as:
Right of existing shareholders in a corporation to purchase newly issued stock before it is offered to others.
This preemptive right definition is quite simple and to the point.
It’s essentially a right (not an obligation) to purchase additional shares in a company’s capital stock when new equity securities are issued.
Why is a preemptive right important?
Preemptive rights are important rights granted to shareholders to protect them from the future dilution of value or control.
They have significant importance for early investors, private equity investors, VCs and other private investors.
Essentially, a preemptive right protects the shareholder from losing voting power the more the company issues stocks bearing voting rights.
Benefits to shareholders
The right of preemption can also be beneficial to a shareholder by offsetting some losses in the common stock price.
For instance, if a shareholder was issued preferred shares, he or she may have the right to convert the preferred shares to common shares in the event the new common shares are issued at a price lower than the preferred shares.
Let’s look at an example.
Imagine you have 100 convertible preferred shares in Top Consultants Inc purchased at $20 per share.
Being convertible preferred shares, you have the right to convert them into common stocks.
Imagine that the company intends to issue common stocks at $15 per share.
Evidently, you do not have any incentive to convert a $20 preferred stock for a $15 common stock.
However, the preferred shareholder can be protected by converting the preferred shares into “more” common stocks protecting him or her against loss of value in the common shares.
Instead of converting 100 preferred shares for 100 common shares, you’d convert your preferred shares for say 110 common shares.
Benefits to companies
Companies also benefit by issuing shares to current shareholders when it expects that the current shareholder base will exercise their right of preemption to buy newly issued shares.
In this case, the cost of capital will be lower for the company who will not need to pay finders fees, investment banking service fees or other fees to issue shares to the public.
At the end of the day, the company saves money when raising capital.
Lower cost of equity helps increase the value of the business.
Preemptive rights vs right of first refusal
Preemptive rights and the right of first refusal are very similar and operate in the same way.
Preemptive rights allow a shareholder to purchase shares issued by the company in the future to preserve the same prorated equity ownership in the company.
The first right of refusal (or ROFR) is the right given to a shareholder to purchase a selling shareholder’s shares.
In other words, if a shareholder intends to sell to a third party, before having the right to sell to a third party, he or she must offer the other shareholders having a ROFR to purchase the shares intended for sale.
The objective of preemptive rights and the right of first refusal is the same.
It allows the current shareholders to protect their equity interest percentage in the business and voting power.
One right gives the shareholder the ability to buy new shares whereas the other right allows a shareholder to purchase the shares from another shareholder who wishes to sell them.
Preemptive rights vs anti-dilution rights
Preemption rights are the rights granted to current shareholders to buy additional shares of the company in the future.
Anti-dilution rights are rights given to shareholders and investors to protect them from share dilution.
Typically, anti-dilution rights apply to financing done at a lower valuation than what the shareholder initially paid for the stock.
When that happens, the investor’s shares, options and convertible securities are adjusted upwards so that the investor is compensated for the lower company valuation.
Preemptive right example
Let’s look at a concrete example to see how preemption rights work.
Let’s say Top Consultants Inc. has 10,000 common stocks issued and outstanding.
John, Marc, Mary, and Helen own 2,500 common shares giving them a 25% stake in the business.
They also have preemptive rights should the company issue additional common stocks in the future.
At some point in time, the company’s board of directors decides to issue an additional 100,000 common stocks to raise capital to expand their operations.
Before the company can issue the shares to the general public or third parties, John, Marc, Mary and Helen have to decide if they will exercise their preemption rights or not.
To exercise their shareholder preemptive rights, each shareholder can purchase an additional 25% of the common stock the company intends to issue.
In other words, each shareholder can purchase up to 25,000 shares in the new investment round.
Let’s assume that John and Mary exercise their option to buy 25,000 each while Marc and Helen do not.
They submit a preemptive rights notice to the company to notify the board of directors of their intention to exercise their shareholder rights.
In that case, John and Mary will have to pay the company the common stock purchase price so they can each preserve their 25% equity interest in the business.
However, since Marc and Helen did not exercise their preemptive rights, the company sold the remaining 50,000 shares to Jack as a new investor.
Now, the company will have a total of 110,000 shares outstanding and the shareholder base includes:
- John 2,500 + 25,000 = 27,500 shares (25% equity interest)
- Marc 2,500 (2.27% equity interest)
- Mary 2,500 + 25,000 = 27,500 shares (25% equity interest)
- Helen 2,500 (2.27% equity interest)
- Jack 50,000 (45.46% equity interest)
As you can see, John and Mary were able to protect their percentage ownership in the company and avoid dilution whereas Marc and Helen got significantly diluted.
An early investor will want to maintain his or her percentage ownership in a business if things are going well in the future.
Without the preemptive right of shareholders, early investors can be quickly diluted and may not reap the intended rewards they initially had in mind.
Preemptive rights clause
Here is an example of how the provision of a preemptive right can be drafted:
If the shareholders approve the additional issuance of shares, Top Consultants Inc (“Company”) hereby grants the shareholders preemptive rights to subscribe for the newly authorized shares of common stock on a prorated basis to their shareholdings at a record date to be established share issuance date.
Preemptive rights FAQ
What is preemptive right?
A preemptive right is the right of an investor to maintain the same percentage equity interest in a company by having the right to purchase a proportionate number of shares in future security issuance rounds.
You are often likely to see a preemptive rights clause in an investment agreement, option agreement, merger agreement or other.
It’s rare in the United States to see publicly traded companies grant preemptive rights to their shareholders.
Such rights are typically granted to early investors such as venture capital firms, private equity investors, angel investors, or others in a startup or private business.
How preemptive rights work
Preemptive rights allow current shareholders of the company to protect their value and control in the business.
Typically, shareholders having preemptive rights are issued subscription warrants specifically indicating how many shares of newly issued stock they can purchase.
Suppose a shareholder has 25% current ownership in a corporation.
In that case, their preemptive rights will allow them to buy up to 25% of the newly issued stocks so it can maintain the same percentage voting rights and control of the business.
By keeping the same voting rights, the shareholder also protects his or her investment in the business by preserving a 25% stake.
Shareholders having preemptive rights will be able to participate in future financing rounds to purchase a sufficient number of shares to keep the company’s same percentage ownership.
In some cases, investors are given the right to subscribe to more shares than their percentage ownership in the company.
That’s when we refer to a “super preemption right”.
The super preemption right grants the investor the right to purchase shares over and above his or her pro-rata ownership in a corporation.