# Understanding Preemptive Rights: Protect Your Investment in New Stock

## What Are Preemptive Rights?

Preemptive rights give a shareholder the opportunity to buy additional shares in any future issue of a company's common stock before the shares are made available to the general public. These rights usually apply only to [early investors](https://www.investopedia.com/articles/financial-theory/11/6-lessons-top-6-investors.asp) and offer them a first option to purchase additional shares. Preemptive rights help maintain investment value and protect ownership percentage in a company. As a result, they're sometimes referred to as an anti-dilution provision. In the United States, the law does not require preemptive rights for all common shareholders. In the European Union and the UK, it does.

### Key Takeaways

*   Preemptive rights allow shareholders to maintain their ownership stake by purchasing additional shares before new stocks are publicly available, protecting against dilution of their equity and voting power.
*   Typically featured as anti-dilution provisions, these rights offer significant advantages to early investors and company insiders by allowing them to purchase new shares at preferential prices, particularly protecting their interests if new shares are issued at lower prices.
*   Preemptive rights are more commonly offered in Europe and the UK under legal statutes, whereas in the U.S., they are generally reserved for early investors through contractual agreements noted in company charters.
*   There are two main types of preemptive rights provisions: weighted average and ratchet-based, each offering mechanisms to adjust the purchase price or share amount to sustain ownership percentages as new stock issues arise.

![Preemptive Rights: Giving a shareholder the right to buy additional shares of a new issue in order to maintain the size of an ownership stake in the company.](https://www.investopedia.com/thmb/HMArzuxRVo7vpOx5M8h7x43PbW8=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Preemptiveright_final-bdf3a246b83f4d47a4cba3c3ec56c2f0.png)

*— Investopedia / Michela Buttignol*

## How Do Preemptive Rights Work?

A preemptive right is essentially a right of first refusal. The shareholder may exercise the option to buy additional shares but is under no obligation to do so.

Preemptive rights are often used to attract early investors who are willing to risk financing new ventures. These investors usually buy convertible preferred shares when the company is private, and later, they can convert these into common shares once the company is public.

The use of preemptive rights in the U.S. is notably different from that of European Union nations and Great Britain, where preemptive rights for purchasers of common stock are required by law.

This right is not routinely granted to shareholders in the U.S. Several states grant preemptive rights as a matter of law but even these laws allow a company to negate the right in its articles of incorporation.

Preemptive rights protect investors if new stock is issued at a lower price than their [preferred stock](https://www.investopedia.com/articles/active-trading/101614/what-you-need-know-about-preferred-stock.asp). They have the right to convert preferred shares into more common shares, minimizing any potential loss.

> **Important**
>
> The preemptive right offers the shareholder an option but not an obligation to buy additional shares of stock.

## Different Types of Preemptive Rights Clauses Explained

Contracts may offer two preemptive rights types: weighted average and ratchet-based provisions.

*   The weighted average provision allows the shareholder to buy additional shares at a price that is adjusted for the difference between the price paid for the original shares and the price of the new shares. There are two ways to calculate this weighted average price: the "[narrow-based](https://www.investopedia.com/terms/n/narrowbasedweightedaverage.asp)" weighted average and the "[broad-based](https://www.investopedia.com/terms/b/broadbasedweightedaverage.asp)" weighted average.
*   The ratchet-based provision, or "[full ratchet](https://www.investopedia.com/terms/f/fullratchet.asp)," allows a shareholder to convert preferred shares to new shares at the lowest sales price of the new issue. If the company's new shares are priced lower, the shareholder is effectively compensated with a greater number of shares in order to maintain the same level of ownership.

## Advantages of Holding Preemptive Rights

Major investors with significant stakes find preemptive rights useful for maintaining influence over company decisions. Few individual investors own enough shares to worry about their fractional percentage declining among millions of shares. Those more likely to benefit are early investors and company insiders.

### The Benefit to Shareholders

Preemptive rights protect a shareholder from losing voting power as more shares are issued and the company's ownership becomes [diluted](https://www.investopedia.com/terms/d/dilution.asp).

Shareholders get an insider price on new shares, which can be a strong profit incentive.

In the worst case, there is the option of reducing losses by converting preferred stock to more shares if the new issue is priced lower.

### The Benefit to Companies

Preemptive rights incentivize early investors and offer benefits to the company granting them.

It is less expensive for a company to sell additional shares to its current shareholders than to issue additional shares on a public exchange. Issuing public stock involves hiring investment banks to manage the sale.

The savings in direct sales to existing shareholders lower the company's cost of equity, and hence its cost of capital, increasing the firm's value.

Preemptive rights also are an additional incentive for a company to perform well so it can issue a new round of stock at a higher price.

## Practical Example: How Preemptive Rights Operate

Let's assume that a company's [initial public offering](https://www.investopedia.com/terms/i/ipo.asp) (IPO) consists of 100 shares and an individual purchases 10 of the shares. That's a 10% equity interest in the company.

Down the road, the company makes a secondary offering of 500 additional shares. The shareholder who holds a preemptive right must be given the opportunity to purchase as many shares as necessary to protect that 10% equity stake. In this example, that would be 50 shares if the prices of both issues were the same.

The investor who exercises that right will maintain a 10% equity interest in the company. The investor who opts not to exercise the preemptive right will still have 10 shares, but they will represent less than 2% of the outstanding shares.

## Preemptive Rights FAQs

Here are the answers to some commonly asked questions about preemptive rights.

### What Are Preemptive Rights Shares?

Preemptive rights give a shareholder the option to buy additional shares of the company before they are sold on a public exchange. They are often called "anti-dilution rights" because their purpose is to give the shareholder the ability to maintain the same level of voting rights as the company grows. Otherwise, the shareholder's stake would dwindle as the number of shares in other hands increases.

### Why Are Preemptive Rights Shares Important to Shareholders?

Preemptive rights are an additional incentive for early investors to take on the risk of funding a new venture well before it begins making money or launches an initial public offering (IPO). These rights are rarely made available to regular investors in the U.S. although they are commonly offered by European companies.

### Do Common Shareholders Have Preemptive Rights?

> **Fast Fact**
>
> If you have preemptive rights, you should have received a subscription warrant when you bought the stock. This entitles you to buy a number of shares of a new issue, usually equal to your current percentage of ownership.

U.S. corporations are not required by law to offer their common shareholders preemptive rights, and most don't. Those that do outline the rights in their company charters. If this is the case, the shareholder should receive a subscription warrant entitling them to buy a number of shares of a new issue before is release on the public exchange. The number will usually be equal to their current percentage of ownership.

Great Britain and the European Union recognize the preemptive rights of common shareholders. However, in the U.S., such rights are generally awarded only to early investors and other insiders who have purchased shares or been awarded options in companies that have yet to go public.

They are used as an incentive to investment and a commitment that the holder of preemptive rights will be able to retain voting rights at the same level as the company grows.

### What Is a Waiver of Preemptive Rights?

The U.S. Securities and Exchange Commission (SEC) provides a form that allows the removal of preemptive rights from a previous agreement if both parties agree to the change.

In the U.K., preemptive rights can be canceled if every shareholder signs a waiver. In the absence of such a waiver, the company must pursue a legal process if it wishes to cancel its preemptive rights.

## The Bottom Line

Preemptive rights in the U.S. allow certain shareholders to protect their stock ownership percentage when new shares are issued, preventing dilution of voting and ownership power. These rights are usually provided to early investors and major stakeholders in a company. Preemptive rights serve as a safeguard against losses by allowing shareholders to purchase additional shares at a potentially advantageous price, cushioning the impact of any price reductions in newly issued shares. Companies benefit by issuing fewer public shares, reducing their cost of equity, and potentially increasing their firm's value. Preemptive rights are not universally mandated in the U.S.

> **Article Sources**
>
> 1.  Penn State Law eLibrary. "[Issuing New Shares and Preemptive Rights: A Comparative Analysis](https://elibrary.law.psu.edu/cgi/viewcontent.cgi?article=1279&context=fac_works)." Accessed April 16, 2021.
>     
> 2.  Legal Information Institute. "[Preemptive Right](https://www.law.cornell.edu/wex/preemptive_right)." Accessed April 16, 2021.
>     
> 3.  Penn State Law eLibrary. "[Issuing New Shares and Preemptive Rights: A Comparative Analysis](https://elibrary.law.psu.edu/cgi/viewcontent.cgi?article=1279&context=fac_works)." Accessed April 16, 2021.
>     
> 4.  Securities and Exchange Commission. "[Waiver of Preemptive Rights](https://www.sec.gov/Archives/edgar/data/1130166/000119312503085295/dex108.htm)." Accessed April 16, 2021.
>     
> 5.  Simply-Docs. "[Deed of Waiver of Pre-emptive Rights](https://simply-docs.co.uk/Issue-Transfer-and-Allotment-of-Shares/Deed-of-Waiver-of-Pre-emption-Rights)." Accessed April 16, 2021.