Common Stock: What Are Preemptive Rights?

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When buying a security or option, it is important to look at what features the purchase will entail. Many times what may be included are preemptive rights, which may go by many different names, such as an “anti-dilutive” covenant or privilege.

For many investors– especially larger ones with a greater share of equity in a business– this is a very attractive feature.

Why Do Investors Care How Many Other Investors There Are?

If an investor holds a larger share of equity in a business, they usually hold certain privileges such as greater proportional voting power and they likely do not want to give that up. When more shares are issued, it dilutes their proportional percentage of equity.

Therefore, the power of a preemptive right allows an investor to buy the shares being offered from any new issuance of stock, preserving their proportional share of equity in the business. After the existing shareholders have the chance to buy into the additional shares, then the corporation is allowed to offer the new shares to potential new shareholders.

Are There Any Other Benefits To a Preemptive Right?

Before the new share offering, there is what is called a rights offering. Existing shareholders are given rights– the number of rights being based on their number of existing shares– to buy a certain number of new shares at a discount to the current market price of the security.

If the discount is substantial enough, this can be a great benefit for existing shareholders to increase or maintain their current equity in a corporation while potentially making greater returns on their investment.

This right can be a very powerful tool for a large investor to preserve their ownership and voting power in a business. The preemptive right essentially protects the risk of their share diluting. In a way, it’s like having insurance on your security purchase.

 


Disclaimer: This information does not constitute financial advice. For specific information concerning your financial situation, please consult your local financial advisor.

Author: Foxx Financial

We are focused on financial literacy and a want to help others grow assets, reduce and remove debt, or just understand financial concepts better. The site will be updated often so subscribe for more content.

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