Question

PB2. You are the president of Duke Company and are leading the company through the process of incorporation. The company has determined that common stock shares will be issued, but several key executives at Duke are not quite sure they understand the preemptive right feature associated with common shares. Prepare a memo to your executive team outlining the meaning of this right.

Answer 1

Answer) Preemptive rights -

Definition-

Preemptive rights are a contractual clause giving a shareholder the right to buy additional shares in any future issue of the company's common stock before the shares are available to the general public. Shareholders who have such a clause are generally early investors or majority owners who want to maintain the size of their stake in the company when and if additional shares are offered.

Example-

Let’s assume that John is a 51 percent owner of John’s Garments, Inc. This garments company has several store locations and multiple other investors. In order to finance another location, John’s Garments has decided to issue 1,000 new shares to investors.

Since John is a 51 percent owner of the corporation, he has the right to purchase 51 percent of the newly issued shares. This right is called a preemptive right because John can preemptively stop other investors from purchasing these shares. This is John’s right; however, it is not an obligation. John does not have to purchase all or even some of the newly issued shares. If John decides not to exercise his right to maintain his ownership percentage, his interest in the company will decrease in proportion to the other investors and he will no longer own the controlling interest of the company.

Corporate takeovers and major changes in shareholder ownership often revolve around this concept.