The Preemptive Right
Common stockholders often have the right, called the preemptive right, to pur-
chase any additional shares sold by the firm. In some states, the preemptive
right is automatically included in every corporate charter; in others, it must be
specifically inserted into the charter.
The purpose of the preemptive right is twofold. First, it prevents the man-
agement of a corporation from issuing a large number of additional shares and
purchasing these shares itself. Management could thereby seize control of the
corporation and frustrate the will of the current stockholders. The second, and
far more important, reason for the preemptive right is to protect stockholders
against a dilution of value. 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 the new total
market value is divided by new total shares outstanding, a value of $75 a share
is obtained. The old stockholders would thus lose $25 per share, and the new
stockholders would have an instant profit of $25 per share. Thus, selling com-
mon stock at a price below the market value would dilute its price and transfer
291Chapter 9 Stocks and Their Valuation
Takeover
An action whereby a
person or group
succeeds in ousting a
firm’s management and
taking control of the
company.
Preemptive Right
A provision in the
corporate charter or
bylaws that gives
common stockholders
the right to purchase
on a pro rata basis new
issues of common
stock (or convertible
securities).
Proxy Fight
An attempt by a per-
son or group to gain
control of a firm by
getting its stockholders
to grant that person or
group the authority to
vote their shares to
replace the current
management.
Identify some actions that companies have taken to make takeovers more difficult.
What is the preemptive right, and what are the two primary reasons for its existence?