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.
Types of Preemptive Rights
There are several variations on the preemptive rights concept, which are as follows:
Statutory preemptive rights. These are rights granted automatically under corporate law in some jurisdictions unless explicitly waived or altered in the company’s charter or bylaws. Shareholders can purchase additional shares before the public offering to avoid dilution.
Contractual preemptive rights. These rights are created through shareholder agreements or investment contracts and are not required by law. They are tailored to specific investors, often used in venture capital or private equity deals.
Negotiated preemptive rights. These are preemptive rights that are individually negotiated between a company and select investors, often during private placements or funding rounds. Terms vary based on the investor’s influence or strategic importance.
Pro-rata preemptive rights. A form of preemptive right allowing shareholders to purchase new shares in proportion to their current holdings, ensuring they can maintain the same ownership percentage.
Super preemptive rights. These give investors the right to purchase more than their pro-rata share in future rounds, often used to increase their stake or prevent control from shifting to others.
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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%.