Preemptive Rights

What It Is:

Preemptive rights are a clause in an option, security or merger agreement that gives the investor the right to maintain his or her percentage ownership of a company by buying a proportionate number of shares of any future issue of the security.

How It Works/Example:

Preemptive rights are sometimes called "subscription rights," "anti-dilution provisions," or "subscription privileges." Preemptive rights are particularly relevant for convertible preferred stock. Here is an example.
 
Assume you purchase Private Company XYZ preferred stock for $15 per share. The preferred stock is convertible, which means that you have the right to trade one share of preferred stock for one share of common stock.

Now let's assume Company XYZ wants to go public and issue common shares at $10 per share. This clearly devalues the incentive to convert your preferred share into common shares, because you'd be trading your $15 investment for a common share worth only $10. Preemptive rights could protect you from this if they state that if Company XYZ issues shares at a price lower than in previous financing rounds, the preferred shareholder gets more shares of common stock when he or she converts.

There are two kinds of preemptive rights: the "weighted-average" provision and the "ratchet-based" provision. The ratchet provision offers existing shareholders the right to buy shares at the new lower price. The weighted-average provision gives shareholders the right to purchase shares at a price that accounts for the change in the old and new offering prices.

Why It Matters:

Preemptive rights protect investors from the risk of new shares being issued at a lower price than the investors previously received. They also are an incentive for companies to perform well so they can issue stock at higher valuations when need be.