Limited preemptive right: Overview, definition, and example
What is a limited preemptive right?
A limited preemptive right is a provision in a shareholder agreement or corporate charter that gives existing shareholders the right to purchase additional shares in a company before those shares are offered to outside investors. This right is considered "limited" because it is typically subject to certain conditions, such as the maximum number of shares that can be purchased, the time period in which the right can be exercised, or the specific circumstances under which the right can be exercised.
The purpose of a limited preemptive right is to protect existing shareholders from dilution of their ownership stake when the company issues new shares. It ensures that existing shareholders have the opportunity to maintain their proportional ownership in the company by purchasing additional shares on the same terms as those offered to new investors.
Why is a limited preemptive right important?
A limited preemptive right is important because it helps existing shareholders protect their ownership interests in the company. Without such a right, shareholders could see their ownership percentage diluted if the company issues additional shares to new investors. This could reduce their control over company decisions, as well as the value of their holdings.
For companies, offering a limited preemptive right can help maintain a more stable shareholder base and prevent unwanted external parties from gaining significant control of the company. It can also foster goodwill with existing investors by providing them with the opportunity to maintain their stake in the company.
Understanding limited preemptive right through an example
Imagine a company, ABC Corp., has 1,000 shares outstanding, and one shareholder, John, owns 100 shares, or 10% of the company. ABC Corp. decides to issue an additional 500 shares to raise capital for expansion.
Because of a limited preemptive right in ABC Corp.’s shareholder agreement, John has the option to purchase up to 50 additional shares (his 10% proportion of the new 500 shares) before the shares are offered to new investors. John can exercise his limited preemptive right and purchase the additional shares, maintaining his 10% ownership in the company. If he chooses not to exercise his right, the new shares will be offered to other shareholders or outside investors.
In another scenario, the company may set specific timeframes for John to exercise his right—perhaps allowing him only 30 days to decide whether to purchase the shares before they are offered to others. This would be an example of the limited aspect of the preemptive right.
Example of limited preemptive right clause
Here’s how a limited preemptive right clause might appear in a shareholder agreement:
“In the event that the Corporation issues additional shares of stock, each shareholder shall have a limited preemptive right to purchase a proportionate number of such shares, based on the percentage of shares owned by such shareholder at the time of the issuance. This right must be exercised within 30 days of receiving notice of the issuance, and the right to purchase shall be limited to no more than [insert percentage] of the total number of shares being issued.”
Conclusion
A limited preemptive right provides existing shareholders the opportunity to maintain their proportional ownership in a company when new shares are issued. By giving shareholders the chance to purchase additional shares before they are offered to external investors, it helps protect their ownership stake and control within the company.
For both companies and shareholders, the limited preemptive right is an important tool for managing ownership and preventing unwanted dilution of control. However, the limitations on the right—such as time frames and the number of shares that can be purchased—ensure that the right is exercised under specific conditions and does not hinder the company’s ability to raise capital.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.