The preemptive right enables current stockholders to maintain control and prevents
a transfer of wealth from current stockholders to new stockholders. If it were not for this
safeguard, the management of a corporation could issue a large number of additional
shares and purchase these shares itself. Management could thereby seize control of the
corporation and steal value from the current stockholders. 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 total market
value is divided by new total shares outstanding, a value of $75 a share is obtained. The
old stockholders thus lose $25 per share, and the new stockholders have an instant profit
of $25 per share. Thus, selling common stock at a price below the market value would
dilute its price and transfer wealth from the present stockholders to those who were al-
lowed to purchase the new shares. The preemptive right prevents such occurrences.
What is a proxy fight?
What are the two primary reasons for the existence of the preemptive right?
Types of Common Stock
Although most firms have only one type of common stock, in some instances classi-
fied stockis used to meet the special needs of the company. Generally, when special
classifications are used, one type is designated Class A,another Class B,and so on.
Small, new companies seeking funds from outside sources frequently use different
types of common stock. For example, when Genetic Concepts went public recently, its
Class A stock was sold to the public and paid a dividend, but this stock had no voting
rights for five years. Its Class B stock, which was retained by the organizers of the
company, had full voting rights for five years, but the legal terms stated that dividends
could not be paid on the Class B stock until the company had established its earning
power by building up retained earnings to a designated level. The use of classified
stock thus enabled the public to take a position in a conservatively financed growth
company without sacrificing income, while the founders retained absolute control
during the crucial early stages of the firm’s development. At the same time, outside in-
vestors were protected against excessive withdrawals of funds by the original owners.
As is often the case in such situations, the Class B stock was called founders’ shares.
Note that “Class A,” “Class B,” and so on, have no standard meanings. Most firms
have no classified shares, but a firm that does could designate its Class B shares as
founders’ shares and its Class A shares as those sold to the public, while another could
reverse these designations. Still other firms could use stock classifications for entirely
different purposes. For example, when General Motors acquired Hughes Aircraft for
$5 billion, it paid in part with a new Class H common, GMH, which had limited vot-
ing rights and whose dividends were tied to Hughes’s performance as a GM subsidiary.
The reasons for the new stock were reported to be (1) that GM wanted to limit voting
privileges on the new classified stock because of management’s concern about a possi-
ble takeover and (2) that Hughes employees wanted to be rewarded more directly on
Hughes’s own performance than would have been possible through regular GM stock.
GM’s deal posed a problem for the NYSE, which had a rule against listing a com-
pany’s common stock if the company had any nonvoting common stock outstanding.
GM made it clear that it was willing to delist if the NYSE did not change its rules. The
NYSE concluded that such arrangements as GM had made were logical and were
likely to be made by other companies in the future, so it changed its rules to accom-
modate GM. In reality, though, the NYSE had little choice. In recent years, the
Types of Common Stock 189
Stocks and Their Valuation 185
