What are the pre-emption rights?
Pre-emption rights are a contractual clause giving a shareholder the right to purchase additional shares in any future issue of the company’s common shares before the shares are available to the general public. The shareholders who have such a clause are generally early investors or majority owners who wish to maintain the size of their stake in the company when and if additional shares are proposed.
A pre-emptive right is sometimes called an “anti-dilution provision”. It gives the investor the opportunity to retain a certain percentage of ownership of the business as it grows.
Key points to remember
- A pre-emptive right allows an early investor to maintain voting power in a company even if new shares are issued.
- The law can also protect the early investor from loss if the new shares are cheaper than the original shares.
- Preemption rights are systematically offered only to first investors and majority shareholders, not to all shareholders.
In addition, the pre-emptive right can protect the investor from loss if the new series of common shares is issued at a price lower than the preferred share held by the investor. In this case, the owner of preferred shares has the right to convert the shares into more common shares, thereby offsetting the loss in value of the shares.
Understanding the right of first refusal
The pre-emption right clause is commonly used as an incentive for early investors in exchange for the risk taken in financing a new business.
This right is not systematically granted to all shareholders. Several states grant pre-emptive rights in law, but even these laws give the company the possibility of negating this right in its statutes.
A right of first refusal is essentially a right of first refusal. The shareholder can exercise the option to purchase additional shares but is not required to do so.
The advantage for shareholders
Pre-emption rights protect a shareholder against loss of voting rights as more shares are issued and company ownership is diluted.
Since the shareholder gets an insider price for the shares in the new issue, there may also be a strong profit incentive.
At the very least, it is possible to convert the preferred shares into more shares if the new issue is cheaper.
The advantage for companies
It is cheaper for a company to sell shares to current shareholders of a new offer than to sell shares to the general public because the company would not have to pay for investment banking.
These savings would reduce the cost of equity in the business, and therefore its cost of capital, increasing the value of the business.
Preemption rights are also an incentive for companies to perform well so that they can issue a new series of shares at a higher valuation if necessary.
The pre-emptive right offers the shareholder an option but not an obligation to buy additional shares.
Example of preemption rights
Suppose that a company’s initial public offering (IPO) consists of 100 shares and that an individual buys 10 shares. This represents a 10% stake in the company.
Along the way, the company made a secondary offer of 500 additional shares. The shareholder who has a pre-emptive right must be able to buy up to 50 shares, or 10%, of the new offer. The investor can exercise this right and keep a 10% stake in the company.
If the investor decides not to exercise the pre-emptive right, the company will sell the shares to other parties and the percentage of ownership of the anticipated shareholder in the business will decrease.