What are pre-emption rights?
Pre-emption rights, also known as “first refusal rights” or “right of first refusal,” are contractual provisions that give existing shareholders the opportunity to purchase additional shares before the company offers them to external parties. This ensures that current shareholders have the chance to maintain their proportional ownership in the company, thereby safeguarding their level of control and influence.
What’s the purpose of pre-emption rights?
In terms of the pre-emption rights on the transfer of shares, their primary function is to help maintain the existing shareholder base and limit the ability for an unknown third-party shareholder to become involved in the company. It is therefore important for a shareholder wishing to sell or gift their shares to another person (or a company looking to approve the registration of such a transfer) to understand what pre-emption rights exist and what process must be followed before the shares can be sold.
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Why are pre-emption rights important?
Pre-emption rights are important for shareholders as they give them the right to first refusal to purchase new or existing shares. This is designed to protect the interests of shareholders from a dilution of shares occurring, allowing the shareholder to maintain their proportions of ownerships. Without pre-emption rights, a shareholder may have no control over their respective shareholding percentage being reduced and therefore the reduction in their value or one shareholder gaining a controlling stake in the company.
Pre-emption rights are important as they provide:
- Control: Pre-emption rights help existing shareholders maintain their voting power in the company.
- Protection: They protect shareholders from dilution, which could otherwise diminish their stake in the company.
- Investor confidence: These rights can make the company more appealing to potential investors, as they provide a level of security and control.
What’s the difference between pre-emption rights and right of first refusal?
Pre-emption rights and right of first refusal are interchangeable terms and therefore mean the same thing. Both relate to the fact that, in the context of a company, shareholders have the opportunity to purchase shares which become available before they can be offered to a third party.
How do pre-emption rights work when new shares are issued?
In terms of pre-emption rights on the issue of new shares, their primary function is to help protect a shareholders’ proportion of voting and other rights in a company from being diluted without their consent. This is because the new shares cannot be offered to other potential buyers without first being offered to the existing shareholders in proportion to their existing shareholding. It is therefore important for a company intending to raise funds by allotting new shares to be aware of any pre-emption rights which may exist and where they may arise.
It is important to note that pre-emption rights do not allow existing shareholders to acquire additional shares for free; a shareholder’s ability to accept a pre-emptive offer for shares will depend on them having the funds to accept the offer and pay for the shares at the proposed or agreed price.
How do pre-emption rights work in a start-up business?
In a start-up business, if pre-emption rights have not been disapplied, before you can bring in any outside shareholder, for example an investor, you would first have to offer the shares to the existing shareholders. This could cause an issue if, when it comes to obtaining funding, a shareholder decides to be difficult and refuses to waive their rights to pre-emption or if you cannot locate a shareholder, but it also acts as a protection to limit dilution of a shareholders shareholding.
How can pre-emption rights arise?
Pre-emption rights can arise in three ways:
- Statutory pre-emption rights under the Companies Act 2006 (in respect of an issue of new shares),
- The provisions of a company’s articles of association (in respect of either an issue of new shares or a transfer of shares),
- The provisions of a shareholders’ agreement (in respect of either an issue of new shares or a transfer of shares).
How can pre-emption rights impact your investment in a business?
Investors will care about having pre-emption rights because it means that they can maintain the same percentage of equity that they had before new shares became available. This avoids dilution occurring but also requires the investor to make further investments into the Company if they wish to maintain their proportional shareholding.
What are statutory pre-emption rights?
Statutory pre-emption rights are detailed in the Companies Act 2006 which prescribes the process to be followed in order to offer existing shareholders any new shares proposed to be issued in proportion to their current shareholding before those shares can be issued to anyone else. If the statutory process applies, a company must follow that procedure strictly and wait the designated time period before the new shares can be issued.
There are certain exceptions that can be considered which may allow shares, in certain circumstances, to be issued without following the statutory pre-emption rights.
The statutory pre-emption rights will apply to the issue of new shares unless they have been disapplied in the company’s articles of association or shareholders’ agreement. In this case, a contractual pre-emption right may apply in place of the statutory process.
Pre-emption rights within the articles of association or under a shareholders’ agreement
Many companies have bespoke articles or a shareholders’ agreement in place which may disapply the statutory rights referred to above and include a different procedure that has to be followed (in place of the Companies Act 2006 provisions) before a company can issue new shares. Bespoke articles and shareholders’ agreements also typically include provisions relating to pre-emption rights which apply on the transfer of shares by a shareholder.
Articles of association are public documents available to view at Companies House, however, a shareholders’ agreement is a private document. Sometimes there are provisions in both the articles and a shareholders’ agreement; these may not be consistent with each other and, in this case, consideration would need to be given to which takes precedence and whether a document needed to be amended before the transaction could proceed.
Often bespoke provisions contained in articles or a shareholders’ agreement may prescribe certain circumstances where shares can be issued or transferred without following the contractual pre-emption process. A common example on transfer is a transfer of shares to a spouse or child of the shareholder.
Whether you are a company proposing to issue new shares or approving the registration of a transfer of existing shares, a shareholder seeking to transfer shares or a person / investor looking to acquire shares in a company, it is important that you are clear on the procedure which is to be followed to ensure that the transaction is properly carried out.
The disapplication of pre-emption rights
It may be the case that it has been agreed with existing shareholders that a third party is to acquire shares (whether by way of transfer or issue). In this situation it is possible, rather than having to follow the applicable process to offer the shares to the existing shareholders and wait for those shareholders to reject the offer or the relevant time period for the offer to lapse, to ‘disapply’ pre-emption rights allowing share issues or transfers to be carried out without the need to first offer the shares to existing shareholders.
The process for disapplying pre-emption rights will depend on the type of pre-emption rights but could, for example, require a shareholder resolution or the written consent of all shareholders.
How Moore Barlow can help
Pre-emption rights are an important provision for shareholders to protect their shareholdings. It is imperative they are properly considered when a new issue of shares or a transfer of existing shares is proposed so that directors (as well as existing shareholders and potential investors) know the correct procedures to be followed to ensure pre-emption rights are either followed or disapplied correctly.
Our corporate solicitors have a wealth of experience in corporate matters and regularly advise on the issue of new shares or the sale or disposal of existing shares. For more information about how our solicitors can help you, contact the Moore Barlow corporate team today.
