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Shareholder Dilution of Ownership

Preemptive Rights Against Shareholder Dilution of Ownership

Understanding preemptive rights against dilution of share ownership.

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Preemptive Rights

Shareholders tend to think of their ownership interests on a percentage basis: “I own 10% of the company.” But ownership is actually measured by the number of shares, so that a 10% shareholder would own 100 shares out of 1000 shares issued. However, if the corporation issues 1000 new shares, then the owner of the 100 shares is suddenly only a 5% owner. This is called dilution, and it is often used as a mechanism to oppress and violate the rights of minority shareholders.

Shareholders are protected from dilution if they have preemptive rights, which enable shareholders to protect their percentage ownership, right to dividends, and voting power. If a shareholder has preemptive rights, then that shareholder must be offered the opportunity to acquire a proportionate number of additional shares on the same terms and conditions any time that new shares are issued. In Texas, preemptive rights were first developed by the courts as a means to protect the interests of individual shareholders. Early in the last century, the law of preemptive rights was codified into statute. The law in Texas has changed significantly over the years. The current statutes governing preemptive rights are at sections 21.203-21.208 of the Texas Business Organizations Code. As the law now stands, corporations formed prior to September 1, 2003 have preemptive rights, unless the certificate specifically provides otherwise. Corporations formed after that date do not, unless the certificate specifically grants them. Consequently, preemptive rights are relatively rare for Texas shareholders.

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Preemptive Rights Work

How Preemptive Rights Work

Shares sold by an existing corporation may come from three sources: (a) newly authorized shares; (b) previously authorized shares that were never issued; or (c) treasury shares, that were once issued and have been repurchased by the company. When a corporation issues new shares or sells treasury shares, a shareholder with preemptive rights has a sort of right of first refusal to purchase his proportionate share of the offering on the same terms in order to maintain his share ownership percentage and avoid shareholder dilution.

However, the Code provides that the following types of issuances are exempt from preemptive rights, unless the share certificate provides otherwise:

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1. shares issued or granted as compensation to a director, officer, agent, or employee of the corporation or a subsidiary or affiliate of the corporation;

2. shares issued or granted to satisfy conversion or option rights created to provide compensation to a director, officer, agent, or employee of the corporation or a subsidiary or affiliate of the corporation;

3. shares authorized in the corporation's certificate of formation that are issued not later than the 180th day after the effective date of the corporation's formation; or

4. shares sold, issued, or granted by the corporation for consideration other than money.

Therefore, even when the shareholder has preemptive rights, corporations or majority shareholders intent on causing shareholder dilution will usually be able to issue shares under one of the exceptions.

The Code provides a special statute of limitations for actions based on preemptive rights. The shareholder must bring his action not later than the earlier of: (a) one year from the date written notice is given to the shareholder that his preemptive rights were violated; or (b) four years from the latest of: (1) the date the corporation issued the relevant shares, securities, or rights; (2) the date the corporation sold the relevant shares, securities, or rights; or (3) the date the corporation otherwise distributed the relevant shares, securities, or rights.

For the most part, in practice, preemptive rights provide little meaningful protection to minority shareholders against dilution of their interests. Minority shareholders faced with a squeeze-out attempt that utilizes shareholder dilution tactics are generally better off pursuing alterative remedies.

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