Understanding Shareholders' Preemptive Rights

A preemptive right is often provided to existing shareholders of a corporation to protect them from involuntary and undesired dilution of their ownership stake. This right gives them the opportunity to buy a proportional interest of any future issuance of common stock to help maintain their initial percentage ownership position in the company.

It must generally be provided for in the articles of incorporation, but this can depend on state legislation.

How Preemptive Rights Affect You—An Example

Let's assume that Company ABC has 100 shares of stock outstanding, and you own 10 of these shares. This gives you 10% ownership. The board of directors decides to sell another 100 shares in the company for $50 each to raise capital to expand. This would dilute your ownership to 5%—10 shares divided by the 200 shares outstanding—if the preemptive right did not exist.

Shareholders are commonly issued "subscriptions warrants" at the time they initially buy-in, citing exactly how many shares they're entitled to buy as a preemptive right. You would agree to buy or subscribe to 10 shares of the new stock if you were to exercise your preemptive right to maintain your proportional interest.

You would then cut a check for $500—10 new shares at the $50 offering price—and you would own 20 out of 200 outstanding shares. You would still own the same 10% of the entire company.

Fast Forward Five Years

Now imagine that Company ABC announces a major expansion and plans to issue 1,000 shares of new common stock five years later. You'd own only 1.67% of the company when the new shares are issued—20 shares owned divided by the 1,200 shares outstanding—if you don't purchase any new shares as part of your preemptive right.

Shareholders must generally have voting rights to have preemptive rights but, again, this can depend on state law.

Follow-On Offerings

It's referred to as a "follow-on offering" when a company issues shares after its initial public offering. There are two types of follow-on offerings: diluted and non-diluted.

A company creates and offers new shares with a diluted follow-on offering, which causes current shareholders to lose some of their ownership stake in the company. Non-diluted follow-on offerings consist of shares that are already in the market.

Advantage to the Company

The primary benefit of preemptive rights for most companies is that it saves them money. They must go through an investment bank for the underwriting when companies want to offer new shares to the general public, and this is a costly process. It's much cheaper for a company to sell shares to current shareholders than it is for them to sell them to the general public.

Disadvantage to the Company

Some companies elect to do away with the preemptive right because it can be inconvenient when they're attempting to raise cash from equity issuance.

One example is when a company issues new shares of stock at prices lower than what the shares are currently trading, knowing full well that the minority shareholders won't be able to purchase the new shares as part of their preemptive right.

The majority shareholder can take advantage of the opportunity to substantially increase their ownership position while simultaneously decreasing the minority shareholders' ownership positions.