Foundations of Financial Management(18th ed). McGraw-Hill Higher Education(US)
Chapter 17 Exercise 3
Preemptive right is a contractual clause provisioned for early investors of a company that gives them an opportunity to buy additional shares in the future events before the shares are available to the general public. This gives the early investors an advantage in a way to maintain their stake in the company.
The rights are allotted with the help of subscription warrants and help them cut their losses if the new shares are priced lower that the initial share prices. In effect, it prevents the new investors from diluting the ownership percentage of initial investors.
There are two main types of preemptive rights:
Weighted average provision – Additional shares are brought at a price adjusted with the average of the difference between the price for the original shares and the new shares.
Ratched-based provision – Buy shares at the lowest price of sell for the newly issued shares
The additional issuance is facilitated by an investment banking service. It is less expensive for a company to issue additional shares to investors as compared to adding them on a public exchange. The preemptive rights in effect play an important role in enticing venture capitalists for raising funds during initial rounds of investment.
