The Preemptive Right
by MaestriCommon stockholders often have the right, called the preemptive right, to purchase any additional shares sold by the firm. In some states, the preemptive right is automatically included in every corporate charter; in others, it is necessary to insert it specifically into the charter.
The preemptive right enables current stockholders to maintain control and prevents a transfer of wealth from current stockholders to new stockholders. If it were not for this safeguard, the management of a corporation could issue a large number of additional shares and purchase these shares itself. Management could thereby seize control of the corporation and steal value from the current stockholders. For example, suppose 1,000 shares of common stock, each with a price of $100, were outstanding, making the total market value of the firm $100,000. If an additional 1,000 shares were sold at $50 a share, or for $50,000, this would raise the total market value to $150,000. When total market value is divided by new total shares outstanding, a value of $75 a share is obtained. The old stockholders thus lose $25 per share, and the new stockholders have an instant profit of $25 per share. Thus, selling common stock at a price below the market value would dilute its price and transfer wealth from the present stockholders to those who were allowed to purchase the new shares. The preemptive right prevents such occurrences.
Taken From : Five-Minute MBA – Corporate Finance
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