Preemptive Rights

Preemptive rights refer to the right available to the shareholder to maintain their ownership stake by giving them the chance to buy a proportional interest in any additional issuance of common stock in the future.

These are the rights granted to certain equity shareholders. 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 shareholder’s ownership interest doesn’t get diluted even if the company issues more shares.

• The preemptive rights are given to the shareholders to maintain their ownership stake by buying a proportional interest in any new common stock issuance. It ensures their ownership remains intact even if the company issues more shares.
• Preemptive rights are also referred to as subscription privileges, anti-dilution, or subscription rights.
• Preemptive rights in shareholder agreements protect existing shareholders from new investors lowering their ownership percentage. Having the right to buy additional shares doesn't mean current shareholders have to. New investors will purchase the shares if they don't, decreasing the current ownership percentage

Preemptive right is the opportunity given to the existing shareholders to subscribe to the newly issued shares of the company before it is open to the public. The shareholder preemptive rights are also known as Subscription rights, Anti-dilution rights, or Subscription privileges.

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 shareholder preemptive rights are necessary to shareholders because it grants the shareholders an opportunity but not an obligation to keep their initial ownership retained even when a company goes for an 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 new issue in proportion to their existing ownership, the company can bring in new investors and resultant proportionate declines in their ownership.

It protects investors from the risk of new shares being issued at a price lower than the price paid by previous investors. It is rather more relevant in the case of Convertible Preference shares.

In short, 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.

It is a common provision found in the shareholder's agreement. The preemptive rights stocks are necessary to shareholders because they prevent new investors from reducing the existing ownership percentage of existing shareholders. It is pertinent to note that having this right does not require an existing shareholder to purchase additional shares compulsorily. The shareholder can choose not to use this right, and in such cases, the shares are sold to new investors, and the existing shareholder's proportion of ownership in the business declines.

Let's discuss the following types.

#1 - Weighted-Average

Under this, the existing shareholder is provided with the right to purchase shares at a price that considers the change in the old price and the new offered price.

#2 - Ratchet

Under this, existing shareholder is provided with the right to buy shares at the new lower price.

Let us understand the concept with some suitable examples.

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 the general public), this will devalue 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) (in this case P) gets more share of common stock when they convert.

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, these rights are necessary to shareholders because it incentivizes companies to perform well to issue stocks at higher valuations whenever the need arises.

Example #2

Let's understand more with the help of one more example:

Anaya Corporation has 1000 shares of stock outstanding. K owns 100 shares of Anaya Corporation, thereby holding 10% of the entire corporation. The 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 stocks, this would dilute his ownership as follows:

• So K holding in Anaya Corporation declined from 10% to 5% in case new issuance of these rights is not available.
• Now let’s assume that Preemptive rights are available to K, and he exercised those rights by subscribing to the new issue in proportion to this existing ownership.

The concept of waivering the preemptive rights clause involves voluntary abandonment or relinquishment of the right and opportunity to participate in the new future issuance of shares of the company. When shareholders waive it, they choose not to exercise their option to purchase the additional shares. Some important facts about the waiver process is given below:

• They may want the company to issue the shares to the general public first. Thus, they give the company the flexibility to do so.
• The agreement or consent of the existing shareholders are need. The consent is taken either through voting or in writing form, depending on the rules and bylaws of the business.
• It is important for shareholders to pay attention to the implications or effect of such waiver. Since they are giving up the opportunity increase in ownership in the company, they are actually diluting their own stake after the new issue. However, still if they chose to waive off, then they believe that the right is not truly for their best interest. It is also important to follow the legal process and requirements in the waiver decision, as per the applicable regulation and agreement.

It is definitely a good idea to go through the legal and procedural rules to understand the rights and obligation of the waiver process and consult a financial expert for the same.

Let us identify the advantages of the financial concept.

• It becomes easy for a business to raise funds from existing early-stage investors and venture capitalists as they are already familiar with the company.
•  The preemptive rights clause 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 searching for new investors.

Some disadvantages of the process are given below:

• It avoids the concentration of ownership in a few early-stage investors only. It allows a business to exercise more control over the business and limits the size of an individual investor's ownership of the business.
• The preemptive rights offering helps the company negotiate better with new investors and command a higher valuation for the business than with the existing investors.
• Many new investors intend to hold significant ownership in the business and want a commitment from management. It becomes challenging to promise a new investor that they will be able to acquire a certain percentage in cases where this right is being provided to early-stage investors as a business is uncertain as to whether or not early investors intend to exercise their preemptive rights.

Both the concepts refer to two different types of rights granted to parties to a contract. But both have some differences as given below:

• The former is the right that a company grants its existing shareholders where they are allowed to subscribe to the newly issued shares before it is open to the public, whereas in the latter, the parties to the transaction are allowed to enter the transaction before any third party.
• In the preemptive rights offering the percentage of ownership of the existing shareholders is protected, whereas in case of the latter the existing shareholder’s first opportunity to purchase the shares is protected.

Thus, the above are some important points of differences between the two.

This article has been a guide to what are Preemptive Rights. We explain its waiver along with examples, differences with right of first refusal & types. We also take preemptive rights examples, advantages, and disadvantages. You may learn more about Private Equity and Venture Capital from the following articles –

• Redeemable Preference Shares
• Drag-Along Rights
• What are Voting Shares?
• Angel Investment vs. Venture Capital
• Private Equity in Brazil