Preemptive Rights (Subscription Rights)

When a corporation issues new shares, existing stockholders face dilution: their ownership percentage shrinks. Preemptive rights are designed to prevent this.

What Are Preemptive Rights?

• A preemptive right is a privilege granted to existing common stockholders allowing them to purchase newly issued shares before the general public gets access
• The purpose is to let shareholders maintain their proportionate ownership (prevent dilution)
• Shareholders receive one right per share owned as of the rights record date
• Preemptive rights are not automatic; they must be granted by the corporate charter

Think of it this way: Imagine you and nine friends each own 10% of a pizza shop. The group decides to bring in two new partners. Without preemptive rights, your 10% slice shrinks automatically. With preemptive rights, you get first dibs on buying enough of the new shares to keep your 10%.

Example: You own 1,000 shares of a company with 10,000 total shares outstanding (10% ownership). The company plans to issue 2,000 new shares. Without preemptive rights, your ownership drops to 8.3%. With preemptive rights, you can buy 200 of those new shares to maintain your 10%.

Exam Tip: Gotchas

• Rights holders have NO voting rights and receive NO dividends. Rights are not shares. You only gain shareholder privileges after you exercise the rights and purchase the new shares.

Exercise Terms

• Rights are short-term instruments, typically expiring within 30 to 90 days of issuance
• The subscription price (exercise price) is set below the current market price, giving each right inherent value
• A specified number of rights plus the subscription price are required to purchase one new share
• Rights holders have three choices:
  • Exercise the rights (buy new shares at the discounted subscription price)
  • Sell the rights on the secondary market
  • Let them expire worthless
• Rights are transferable and trade on exchanges or over-the-counter (OTC) during the subscription period

Exam Tip: Gotchas

• Subscription price is BELOW market value. If the exam describes a subscription price above market, the rights have no intrinsic value and would not be exercised. This is the opposite of warrants, where the exercise price starts above market value.
• Rights are SHORT-term (30-90 days). These are often confused with warrants, which last for years.

Cum-Rights vs. Ex-Rights

The timing of when you buy the stock determines whether you receive the rights.

• The ex-rights date is typically set one business day before the record date (same concept as ex-dividend dates)
• "Cum" is Latin for "with" and "ex" is Latin for "without"

Value of Rights Formulas

These formulas calculate the theoretical value of one right. The exam tests both.

Why the difference?

• The cum-rights formula includes +1 in the denominator because the stock still carries the right (you're buying a stock that comes with a right attached)
• The ex-rights formula omits the +1 because the right has already detached from the stock

Memory Aid: "Cum" means with, so add 1. "Ex" means without, so no +1.

Example (Cum-Rights):

• Market price: $50
• Subscription price: $42
• Rights needed per new share: 3

Value = ($50 - $42) / (3 + 1) = $8 / 4 = $2.00 per right

Example (Ex-Rights) (same numbers):

Value = ($50 - $42) / 3 = $8 / 3 = $2.67 per right

Exam Tip: Gotchas

• Cum-rights formula adds +1 to the denominator; ex-rights does not. The +1 accounts for the right still being attached to the stock. If you see "cum-rights," add 1. If you see "ex-rights," use the number of rights needed as-is.

Standby Underwriting

Not all shareholders will exercise their rights, which could leave unsold shares.

• The issuer may hire a standby underwriter who agrees to purchase any unexercised shares after the subscription period ends
• This is a form of firm commitment: the underwriter buys remaining shares on a firm basis and resells them to investors
• The standby underwriter receives a fee for assuming this risk, typically a percentage of the total offering size
• This arrangement guarantees the issuer will raise the full amount of capital intended