What it is:
How it works (Example):
Preemptive rights are sometimes called "subscription rights," "anti-dilution provisions," or "subscription privileges." Preemptive rights are particularly relevant for convertible preferred stock. Here is an example.
Assume you purchase Private Company XYZ preferred stock for $15 per share. The preferred stock is convertible, which means that you have the right to trade one share of preferred stock for one share of common stock.
Now let's assume Company XYZ wants to go public and issue common shares at $10 per share. This clearly devalues the incentive to convert your preferred share into common shares, because you'd be trading your $15 investment for a common share worth only $10. Preemptive rights could protect you from this if they state that if Company XYZ issues shares at a price lower than in previous financing rounds, the preferred shareholder gets more shares of common stock when he or she converts.
There are two kinds of preemptive rights: the "weighted-average" provision and the "ratchet-based" provision. The ratchet provision offers existing shareholders the right to buy shares at the new lower price. The weighted-average provision gives shareholders the right to purchase shares at a price that accounts for the change in the old and new offering prices.