An Overview of Pre-emptive Rights of Shareholders

Kiran Malik

29 Apr, 2023

The capacity of a shareholder to preserve their ownership investment by acquiring a proportional interest in any upcoming common stock issuance is known as preemptive rights. These are the privileges provided to specific equity owners. The option to buy more shares of a company’s stock is provided to them before the option is extended to any further investors. Existing shareholders have the option to keep their proportionate part of a business’s ownership by purchasing a proportional share of the company’s subsequent stock issuances. By doing this, they may prevent their ownership interest from being diminished even if the firm issues more shares.

• Preemptive rights are essential to shareholders because they provide current shareholders with the ability to purchase a proportional interest in any future issue of common stock, preventing them from having their ownership position involuntarily diluted.
• Preemptive rights are additionally referred to as subscription privileges, anti-dilution rights, and subscription rights.

The shareholder’s agreement frequently has this clause. Because they stop new investors from lowering the existing shareholder’s portion of ownership, preemptive rights are essential to shareholders. It is important to emphasize that exercising this privilege does not mandate that a current shareholder buys more shares under pressure. When a shareholder opts not to exercise this option, their ownership stake in the company decreases because of the sale of their shares to new investors.

Legal obligations to pre-emptive rights

Legal ties formed by statute or contract are known as pre-emptive rights. The right holder has precedence over others in the possible acquisition of the relevant subject matter through exercising their rights. If the right holder refuses to negotiate, a third party is given the opportunity. The Companies Act, 2013,^[1] as well as current security exchange regulations recognize the statutory pre-emptive rights of a shareholder in a firm in India. Contractual pre-emption rights, on the other hand, are governed by the Indian Contract Act of 1872.

Importance of pre-emptive rights

The early phases of a company are risky to invest in. Early-stage investors want to be certain that the risk they took will be compensated with reasonable benefits if the firm succeeds.

These rights are crucial to shareholders because they allow them to exercise their right of first refusal (i.e., only when existing shareholders are not subscribing to the new issue in proportion to their existing ownership will the company be able to attract new investors and the resulting proportionate ownership), which gives them the chance but not the obligation to maintain their initial ownership even when a company goes for an additional round of financing.

Another justification for the necessity for shareholders to have such rights is the risk of new shares being issued at a price less than that paid by previous investors. It is more relevant to convertible preference shares.

Types of pre-emptive rights

The two types of preemptive rights that can be incorporated in a contract are the weighted average provision and the ratchet-based clause.

1. Weighted average provision: The shareholder may acquire more shares at a price adjusted for the cost of the original and additional shares. The weighted average price may be calculated in two ways: narrow-based weighted average and broad-based weighted average.
2. Ratchet-based provision: it gives shareholders the opportunity to convert their preferred shares into new shares at the lowest selling price of the fresh issuance. When a firm issues extra shares at a lower price, the shareholder is compensated with a greater number of shares to maintain the same level of ownership.

Advantages of Preemptive Rights

1. Easy access to capital: Preemptive rights enable a company to raise capital more easily from its existing investors, who are already familiar with the company’s operations, management, and potential. Saving time and money for the company that would have otherwise been spent on searching for new investors.
2. Cost-effective: Preemptive rights can save the company money by eliminating the need for due diligence and excessive negotiations required when seeking new investors, making them cost-effective. Both time and money can be saved when dealing with existing investors who are already familiar with the company and its operations.
3. Maintains control: Preemptive rights enable current shareholders to maintain their proportional ownership in the company, thereby maintaining control. By doing this, the current shareholders maintain their control and prevent any potential dilution of their ownership stake by new investors.
4. Gives you a sense of security: Existing shareholders feel secure because they know they can keep their proportionate ownership in the firm if they use their preemptive rights. This is especially crucial in the situation of a firm in financial distress, because current shareholders may be unwilling to commit new cash without the assurance that their ownership interest will be preserved.

Disadvantages of Preemptive Rights

Preemptive rights offer many advantages, but they also have some disadvantages, such as:

1. Access to new investors may be restricted: Preemptive rights may make it difficult for a firm to attract new investors. Additional investors may be hesitant to invest in a company when present shareholders can purchase additional shares, as this reduces their projected ownership position and restricts their ability to influence corporate decision-making.
2. Limited power over ownership: Preemptive rights to ownership may limit incoming investors jurisdiction over the company. This might be a disadvantage for new investors who want to own a substantial share of the company and have a say in how it is run.
3. limited negotiations: Preemptive rights may limit a company’s ability to negotiate with prospective investors. Prospective investors may be forced to accept a lower valuation for the company if present shareholders exercise their preemptive rights.
4. Uncertainty:Preemptive rights may induce uncertainty of exercise since potential investors may not know if present owners will use their rights or not. As a result, because they are unclear of the future scale of their ownership position, new investors may be unwilling to commit to investing in the business.

Conclusion

Thus, preemptive rights are significant privileges granted to a small group of equity owners that allow them to retain their ownership stake by getting a proportionate share of any approaching common stock offering. They provide a number of benefits, including simple access to finance, cost-effectiveness, control, and a sense of stability for current owners. However, they have drawbacks such as restricted access to new investors, limited negotiations, and unpredictability. Overall, preemptive rights play a crucial role in protecting present shareholder’s ownership interests and are controlled by both statutory and contractual requirements.

Read our Article: Is Shareholder’s Agreement Enforceable in Listed Companies?