Preemptive rights give shareholders the right to purchase enough of newly issued shares to protect their proportionate ownership stakes in a corporation. Preemptive rights are of little value to small retail investors but can be very important for large stockholders with substantial stakes in a company.
Ownership Stake Size
A share of common stock represents an ownership stake in a corporation. The size of an investor’s stake is proportionate to the number of shares he owns relative to the total number of shares outstanding. For example: If XYZ has 1 million shares outstanding, an investor who owns 100,000 shares owns 10 percent of the company.
Secondary Stock Offering
In a secondary stock offering, a company sells new shares to investors to raise capital. A secondary offering increases the total number of shares outstanding. In this example, if XYZ sells 200,000 additional shares, its total shares outstanding will increase to 1.2 million.
After a secondary stock offering, the stake of an investor may shrink. In this example, after a secondary offering, an investor who owns 100,000 shares will see his ownership reduced to 8.3 percent -- that is, it will be diluted. A 10 percent stake may be important to the investor because it gives him a certain amount of control over company affairs. In addition, the same amount of net earnings will now be divided by 20 percent more shares, which will reduce the earnings per share (EPS) by 20 percent, making the shares less valuable.
Exercising Preemptive Rights
If shareholders have preemptive rights, a company issuing more shares in a secondary offering must give them the opportunity to purchase enough shares before offering them to new investors. An investor with a 100,000 share stake will be able to purchase up to 20,000 new shares to keep his ownership stake at 10 percent. If he chooses not to exercise his preemptive right, the company can then offer the shares to new investors.
- “PassTrak Series 7: General Securities Representative License Exam”; Dearborn Financial Services; 2003