What are Preemptive Rights?

 A corporation generally retains the right to issue new shares of stock to existing shareholders or new investors so the corporation can raise additional capital for future expansion, new projects or working capital.  The issuance of such new shares could dilute the ownership percentage of existing shareholders.  For example, if existing shareholders A and B each own 50 of the 100 outstanding shares (50%) of stock of a corporation, and the corporation sells 10 new shares of stock to shareholder B, then shareholder A would own less than 50 percent of the outstanding shares (50/110) if he or she did not also purchase 10 new shares.  If the corporation instead sold 10 new shares of stock to a brand-new investor, both shareholder A and shareholder B would be diluted and own a smaller percentage than they owned before the sale. 

The dilution problem may be exacerbated if the price paid by the new investor is lower than the price paid by the existing shareholders.  For example, if the existing shareholders each paid $100 per share, and the new investor pays $50 per share for the new shares, the existing shareholders not only have a smaller ownership percentage, but the net book value per share of their shares has also been decreased.  Of course, if the real value per share of the corporation has declined to $50 at the time the new investor buys-in, and this is not a short-term temporary slump, the existing shareholders may not be economically disadvantaged by such buy-in.

To avoid these potential dilution problems, existing shareholders are sometimes given preemptive rights.  If granted, preemptive rights allow the shareholders to purchase new shares of stock before such new shares are made available to the public.  If a shareholder exercises preemptive rights, he or she may purchase as many new shares as necessary to retain his or her current ownership percentage. 

In Ohio, under ORC 1701.15, shareholders do NOT have preemptive rights unless granted in the corporation's Articles of Incorporation.  The lack of preemptive rights is not generally a concern for the majority shareholder.  But this can be a huge issue for minority shareholders.  So if you are a minority shareholder, or are considering investing in a business and becoming a minority shareholder, you should seriously explore adding a preemptive rights provision to the corporation’s Articles of Incorporation.  If you would like assistance drafting or amending Articles of Incorporation, give me a call.  Jsenney@pselaw.com or 937-223-1130.

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AND ONE MORE THING.   Shareholders of an “S” corporation are generally permitted to receive tax-free distributions and recognize losses from the corporation to the extent of their basis. A shareholder’s basis is increased by capital contributions and profit allocations, and decreased by distributions and loss allocations.  Losses may not be used in excess of basis (and are carried over).  To increase basis so that losses can be used, shareholders can personally loan money to the corporation.  But merely guaranteeing a corporate debt will not work to increase a shareholder’s basis.  Call if you any help understanding taxation of an “S” corporation and its shareholders.  Jsenney@pselaw.com or 937-223-1130.

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