Pre-emption rights provide existing shareholders (members) of a company first refusal on the issue, transfer, or transmission of shares in that company. These rights are deemed necessary to protect members against involuntary dilution of their existing shareholdings, i.e., a reduction in the percentage of their current stake in the company.
The inclusion of these rights in a company’s articles of association and shareholders’ agreement means that current members must be given the opportunity (but are under no obligation) to purchase available shares, pro-rata to their current shareholdings, before they can be issued or offered to anyone else.
Do all shareholders automatically have pre-emption rights?
If the model articles of association are adopted, existing shareholders are automatically afforded statutory pre-emption rights on the allotment of ordinary shares. Shareholders, however, do not automatically have pre-emption rights under any other circumstances, so these rights should never be assumed without confirmation.
Statutory pre-emption rights are contained within section 561 of the Companies Act 2006. As previously mentioned, this provision applies only on the allotment (issue) of ordinary shares – there are no statutory pre-emption rights on the transfer of existing shares, the transmission of existing shares (i.e., when a shareholder dies or becomes bankrupt), or on the allotment, transfer, or transmission of any share class other than ordinary.
Whilst these statutory rights are sufficient for many small business owners, companies with multiple owners and/or multiple share classes usually require additional pre-emption rights to reflect the company’s needs, protect shareholders, and avoid unnecessary disputes.
Should a company wish to disapply the statutory provision or expand the scope of these rights to include different share classes and/or provide rights on the transfer or transmission of shares, the articles of association and/or shareholders’ agreement must be amended accordingly. Where amendments are made, the procedure for applying or disapplying pre-emption rights should also be outlined in the articles.
What is the procedure regarding statutory pre-emption rights?
The procedure for applying or disapplying pre-emption rights will vary from company to company, depending on whether statutory or amended provisions apply. Directors must refer to the articles and any shareholders’ agreement that exists before issuing or transferring shares, thus ensuring that the correct procedure is followed.
If the statutory provisions defined in the Companies Act apply, the directors will be required to contact existing shareholders (members) in writing to offer available shares in proportion to their current shareholdings, i.e., if the member currently holds 10% of the company’s issued shares, he or she must be offered 10% of any newly allotted shares. This should be done in the first instance, prior to making new shares available to anyone else. Existing shareholders must be given at least 21 days to respond to the offer.
When presented with the option to take newly issued shares, existing members with statutory pre-emption rights may choose to:
- Purchase the additional share(s) on offer
- Decline the offer by informing the company, in writing, that they wish to waive their pre-emption rights in this instance
- Pass a special resolution (which requires a 75% majority vote) to disapply pre-emption rights of all existing members on the specified allotment or transfer.
Should the members choose to waive or disapply these rights, the company may then offer the available shares to third parties, but the terms of the share allotment must not be more favourable than the terms offered to existing members.
Where statutory pre-emption rights on the allotment of shares have been disapplied, or amended provisions are defined in the articles or shareholders’ agreement, the procedure for pre-emption rights may be different.
In such cases, the company must ensure that its articles are properly drafted to include explicit provisions for the allotment, transfer, and transmission of shares and the procedures that directors and shareholders must follow.
What are the benefits of pre-emption rights to shareholders?
The main purpose and benefit of pre-emption rights are to provide existing shareholders with a control mechanism; a way to protect their interests in a company by preventing involuntary dilution of their shareholdings. Essentially, it allows them to keep the same percentage of ownership in the company, regardless of how many new shares are issued.
Further benefits of pre-emption rights include:
- The ability to ensure all investors are suitable, reliable, and possess the means to undertake their required obligations to the company
- To prevent nepotism
- To protect against corruption
- To ensure all existing shareholders are treated fairly
- To protect the company and its members in the event of a shareholder’s death or bankruptcy
- To protect the company and its members against malicious behaviour upon the exit of a disgruntled shareholder
- To prevent majority shareholders from taking advantage of minority shareholders, e.g., by allotting more shares to only themselves and at a low valuation
- To ensure existing members are made aware of any changes to the company’s shareholdings and investors
Whilst pre-emption rights may be of no great concern to private companies that are owned and managed by just one person, they do provide a crucial form of protection to shareholders in companies with multiple shareholders. These rights are of particular benefit and importance to early-stage investors who, understandably, want to minimise the risk they are taking in investing in a new business.
Without the protection of such rights, shares could be issued, transferred, and transmitted to third parties to the detriment of existing members, most notably minority shareholders, thus impacting their voting rights and profit entitlement.
What are the disadvantages of pre-emption rights?
Despite their many benefits, there are a few potential disadvantages to pre-emption rights. In certain situations, these rights can impact the commerciality of a business, deter prospective investors, and cause disputes within a company.
Potential disadvantages include:
- Restricting the commercial freedom of shareholders to sell some or all of their shares to a third party of their choosing
- Deterring third-party buyers – it may be an unattractive prospect to spend significant time and money negotiating the purchase of a company if the sale may never conclude due to shareholder protections in place, which may block the sale
- The potential for future discord within the company, which may prevent third-party investment or buyers
- Restricting the company’s investment options and lowering its valuation, e.g., if a potential investor makes an offer to purchase new shares and the existing shareholders waive their pre-emption rights, the potential investor may be concerned that they offered too much and withdraw their offer. Subsequently, the company may have to sell the shares to existing members at a lower value.
- Existing shareholders may be forced to waive their pre-emption rights if they are not in a position to purchase available shares, thus causing involuntary dilution of their holdings
- Waiving these rights can send a negative signal to third parties – existing shareholders have a better understanding of the company, so their choosing not to reinvest could be interpreted as cause for concern
- A majority shareholder who holds more than 75% of a company’s shares has the power to disapply these rights, thus impacting the interests of minority shareholders.
To minimise these risks whilst reaping the benefits of pre-emption rights, a degree of flexibility is key, coupled with open and effective communication between the company and its shareholders.
Where are pre-emption rights located?
Pre-emption rights may be located in three separate sources of company governance: the Companies Act 2006; the articles of association; and a shareholders’ agreement. It is vital that all of these documents are checked before issuing, transferring, or transmitting company shares.
Pre-emption rights in the Companies Act 2006
Statutory pre-emption rights are located in the Companies Act 2006 (Part 17, Chapter 3, sections 561-577). This legislation provides rights only on the allotment of ordinary shares. There are no statutory pre-emption rights on the transfer or transmission of shares or on the allotment of any share class other than ordinary. Companies can, however, choose to amend their articles to alter their shareholders’ pre-emption rights.
Pre-emption rights in the articles of association
Whilst there are no statutory provisions on the allotment of shares other than ordinary or on the transfer of transmission of shares, it is quite common for companies (and recommended for companies with more than one shareholder) to include these additional pre-emption rights as amendments to the model articles (or Table A, for older companies incorporated before 1 October 2009).
Pre-emption rights in a shareholders’ agreement
A shareholders’ agreement, which is a private contract between members of a company, is advisable when it has more than one shareholder, and pre-emption rights are often included in such agreements.
If a company chooses to amend its articles to include its own pre-emption provisions, it is recommended these provisions should also be included in any shareholders’ agreement.
I don’t have pre-emption rights in my articles, can I introduce them after incorporation?
Most new companies adopt model articles in their entirety during the company formation process, which means that shareholders have only statutory pre-emption rights on the allotment of ordinary shares; however, in accordance with sections 569-573 of the Companies Act 2006, it is possible to amend the articles at any point after incorporation – to remove or alter the statutory provision and/or include additional rights.
To amend the articles after incorporation, the existing shareholders must pass a special resolution at a general meeting or by way of a written resolution. At least 75% of the votes must be cast in favour of the resolution, otherwise the company cannot amend the articles to introduce additional rights. If the company also has a shareholders’ agreement, this must be updated to include the changes reflected in the amended articles.
I have pre-emption rights in my articles, can I remove them permanently?
It is possible to permanently remove statutory pre-emption rights from the model articles. Additional rights included in amended articles can also be permanently removed. To authorise such changes, the existing shareholders of the company must pass a special resolution at a general meeting, or by way of written resolution – both of which must be passed by a majority of no less than 75% of the votes.
Alternatively, rather than permanently removing pre-emption rights from model or amended articles, shareholders can pass a special resolution or a written resolution to disapply rights to specified allotments or transfers on a case-by-case basis.
When do pre-emption rights not apply?
There are a few circumstances where the rules on pre-emption rights do not apply:
- Shares allotted to subscribers (first shareholders) during the incorporation of the company
- On the allotment or transfer of shares under an employee share scheme
- When bonus shares are issued
- On the allotment of shares that are, or are to be, partly or fully paid in the form of non-cash consideration
- The articles of association exclude pre-emption rights or have been amended to include alternative provisions
- A special resolution has been passed to disapply these rights
- When prohibited by other legislation
Most private companies are unlikely to be affected by such circumstances, but it is important to be fully aware of any and all rules that may impact your business or investment portfolio in the future.