What is the Preemptive Right?

Question: What is the Preemptive Right?

You may have heard of the preemptive right of stockholders. Just what is it and how does it affect your ownership position?

Answer: The preemptive right is the right belonging to existing shareholders of a corporation to avoid involuntary dilution of their ownership stake by giving them the chance to buy a proportional interest of any future issuance of common stock. The anti-dilutive preemptive right has also been called the subscription right or subscription privilege.

For example: The Terra Firma Coffee Company has 100 shares of stock outstanding. You own 10 of these shares, or 10% of the entire company. To raise capital to expand, the Board of Directors decides to sell another 100 shares in the company for $50 each. If the preemptive right did not exist, this would dilute your ownership to 5% (10 shares divided by 200 shares outstanding). You excercise your preemptive right to maintain your proportional interest and agree to buy (or "subscribe") to 10 shares of the new stock. You promptly cut a check for $500 (10 new shares x $50 offering price = $500) and now you own 20 shares out of 200 outstanding; the same 10%.

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