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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.
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.
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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, 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.
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.
The two types of preemptive rights that can be incorporated in a contract are the weighted average provision and the ratchet-based clause.
Preemptive rights offer many advantages, but they also have some disadvantages, such as:
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?
Kiran is a multi-talented individual currently pursuing her final year of BBALLB at Chandigarh University. In addition to her studies, Kiran is also a dedicated legal content writer and researcher. She has a keen interest in the legal writing and is committed to using her knowledge and skills to produce informative and insightful content.
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