Preemptive rights are given to the existing shareholders of a company to buy shares of a subsequent issue, if they want, before they are offered to others. The shareholders with preemptive rights get the preference for the shares issued further. They may buy shares from the new issue proportionate to the existing shareholding. Preemptive rights are also known as anti-dilution provisions because they protect the company from dilution of ownership. All shareholders get a part of the ownership of the company. By giving the first option to the existing shareholders, the preemptive rights prevent new shareholders from becoming owners. Hence the ownership is concentrated within the existing shareholders. Also, issuing shares to existing shareholders is cheaper and more convenient for the company than to trade them on a stock exchange. Preemptive rights are usually given to early investors like the investors in an Initial Public Offering (IPO) for the follow-up offerings. IPO is done when the company is formed and issue shares for the first time. All follow-up offers are given after the IPO.
In the U.S., the companies may give preemptive rights to shareholders, but it is not a compulsion. A company may give preemptive rights only if its chart authorizes it to do so. The shareholders with preemptive rights must get a subscription warrant which entitles them to buy shares of a further issue before they are sold to the public.
A close corporation is one whose shares are held by a small group of people who are intimately involved with it. A close corporation is also known as a private company, privately held company, or a family corporation. The shares of close corporations are usually held by the owners and the management of the company. As the shares should be held by a select few, the shares of a close corporation are not listed or publicly traded on a stock exchange.
In most states, a close corporation cannot have more than a certain number of shareholders; in most cases, the limit is 30 to 35. So, the decisions of the company may be taken smoothly and effectively because of the limited number of shareholders. The legal requirements for a close corporation are less compared to a publicly-traded company. For example, a close corporation need not have compulsory general meetings, and it does have to report about its issue of shares to the Securities Exchange Commission (SEC). However, there are a limited number of options for capitalization and divesting shares in a close corporation as they cannot be traded publicly. Many big and well-known companies in the USA like Koch Industries, Cargill Inc., Mars Inc., Ernst and Young, SC Johnson and Deloitte are close corporations.
Preemptive Rights in Close Corporation
The principle behind preemptive rights is to protect the company and the existing shareholders from dilution of ownership and voting rights. As more and more shareholders join the company, the ownership and voting rights of the existing shareholders become lesser. Hence, by giving preemptive rights to the existing shareholders, new shares may be issued without having to approach new shareholders but the existing shareholders, thereby preventing dilution.
Preemptive rights are very important, especially in a close corporation. The shareholders in a close corporation are closely related who have similar and aligned interests. The shareholders of a close corporation form a closed group with identical interests. The general public may not be allowed to become a part of this group as it may disturb the unanimity of the group. Moreover, as a close corporation with few shareholders, the shareholders have considerable voting power.
These shareholders may not want to lose their voting power and control by giving new shares to new shareholders. In fact, the shareholder agreement in a close corporation will typically have a clause for buying back of stock of shareholders who want to exit or have died. So preemptive rights are natural and essential for close corporations.
For better understanding, here is an illustration: A company has 100 shares with 10 shareholders. So, each shareholder has 10 shares and 10 percent of ownership and voting rights. Now the company wants to issue 100 new shares. Let’s imagine they are issued to 10 new members. So, now there are 200 shares and 20 shareholders. Each shareholder holds 10 shares. So each shareholder now has only 5 percent ownership and voting rights (10 out of two hundred).
If there were preemptive rights, the newly issued 100 shares would have to be offered to the existing shareholders only in the proportion of existing shareholding. So, each existing shareholder would get ten shares in addition to the existing ten shares. Then, they would be 200 shares and 10 shareholders with each having 20 shares. That way, the existing shareholder may retain their 10 percent ownership.
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