Preemptive right definition
/What is a Preemptive Right?
A preemptive right is the right of existing shareholders to maintain their proportion of ownership of a company. They do so by acquiring their proportional share of any additional stock issuances by the firm. This right ensures that a shareholder's ownership interest is not diluted through the issuance of more shares. There is no legal requirement for a business to give preemptive rights to its existing shareholders. Instead, it is negotiated on a case-by-case basis. Usually, this right is granted to specific shareholders, typically those who were early-round investors or the founders of a business. Majority owners may also insist on this right, so that they can maintain control over an entity.
The existence of a preemptive right does not require an existing shareholder to purchase additional shares. The shareholder can choose not to exercise the right, in which case shares are sold to other parties and the existing shareholder's proportion of ownership in the business declines.
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Example of Preemptive Rights
A shareholder has 1,000 shares in a company, which currently has 5,000 shares outstanding. At this point, the shareholder owns 20% of the business. The company wants to sell another 5,000 shares in order to raise funds. If the shareholder wants to maintain the same proportional ownership of the business, it must buy 1,000 of these additional shares.
What if the shareholder had decided not to exercise its preemptive rights in this case? Subsequent to the sale of the additional 5,000 shares, the shareholder now owns 1,000 of the 10,000 outstanding shares, so its shareholding percentage has dropped from 20% to 10%.