Pre-emption rights allow existing shareholders to purchase newly available shares proportionate to their current shareholdings before the company offers them to anyone else. These rights are designed to protect the interests of shareholders and limit the ability of external investors to acquire shares.
If you own shares in a company, you should ascertain whether pre-emption rights are available—and if so, the extent of these rights and when they apply. Below, we explain why this is important. We discuss the statutory rights under the Companies Act 2006 and the option of companies to disapply or provide enhanced pre-emption rights in their articles of association and shareholders’ agreement.
What are pre-emption rights?
Pre-emption rights, also known as the ‘right of pre-emption’ or ‘right of first refusal’, are statutory or contractual provisions that give shareholders in a company the right to buy additional shares before external third parties. When such rights apply, any new or existing shares that become available in a company must be offered first and on a pro-rata basis to all of the current shareholders.
For example, if a shareholder owns 25% of the company’s issued shares, and that company provides pre-emption rights, the shareholder has the right of first refusal on 25% of:
- new shares that the company issues (i.e. an allotment of shares) and/or
- existing shares that another shareholder wishes to sell (i.e. a transfer of shares)
This means that each shareholder has the right the purchase the shares, on the same terms as anyone else, before they can be offered to third parties—e.g. the other shareholders, their family members, or external investors. However, while they have the right to purchase the available shares, they are not obligated to do so.
What are the benefits of pre-emption rights?
Providing these rights enables shareholders to preserve their proportional ownership in the company when new shares become available. This protects them against involuntary dilution of their current ownership stake. Dilution occurs when a new issue of shares reduces the ownership percentage of an existing shareholder, which impacts their profit entitlement and voting rights in the company.
- What are my shareholder rights?
- A guide to transferring and issuing company shares
- Rules and restrictions on share transfers in a private limited company
Consequently, pre-emption rights help to maintain the power balance between members. This is particularly beneficial to minority shareholders. Without such restrictions in place, majority shareholders could issue additional shares to themselves or external investors at a lower valuation without offering the same favourable terms to minority shareholders.
The right of pre-emption is also a useful control mechanism for shareholders to restrict external investors or unsuitable third parties from acquiring a stake in the business.
However, where pre-emption rights exist, shareholders are under no obligation to purchase any shares that become available. It is entirely optional. Therefore, shareholders can choose to refuse any such offer by waiving their right of pre-emption at any particular time.
Statutory pre-emption rights under the Companies Act 2006
The Companies Act 2006 provides statutory pre-emption rights to shareholders on the allotment of new shares but not the transfer of existing shares.
On existing shareholders’ rights of pre-emption, the Act states that a company must not issue shares to a person unless—
- it first offers every existing holder of ordinary shares a proportion of the new shares pro-rata to their existing shareholdings and on the same or more favourable terms as the third party
- the period during which the existing shareholders may accept any such offer has expired, or the company has received notice of the acceptance or refusal of every offer made
If a company issues new shares, it must communicate the offer to existing shareholders in hard copy or electronic form. The communication must also specify how much time the member has to accept the offer. This must be at least 14 days.
Exceptions to statutory pre-emption rights
Existing shareholders’ statutory rights of pre-emption on the issue of shares do not apply in the following circumstances:
- The allotment of bonus shares
- Shares issued for non-cash consideration
- Shares issued as part of an employee share scheme
- When a company is in financial difficulty and carries out an allotment of shares as part of a compromise or arrangement with its creditors or members
- When a company holds treasury shares – the company is not treated as a person who holds ordinary shares, so the treasury shares are not treated as forming part of the company’s ordinary share capital
Additionally, statutory pre-emption rights do not apply on a specified allotment once a shareholder waives their right to take up the offer. In such instances, the company can offer the shares to other parties.
In some companies, the directors may have the authority to disapply pre-emption rights in certain circumstances (i.e. on a case-by-case basis). They can do this by passing a board resolution at a board meeting or as a written resolution.
It is also possible for a company to remove statutory pre-emption rights entirely by amending its articles or shareholders’ agreement. However, this decision can only be made by special resolution of the members. To pass this type of company resolution, at least 75% of the members’ votes must be cast in favour of the motion, either at a general meeting or in writing.
Pre-emption rights under the articles or a shareholders’ agreement
Neither the Companies Act 2006 nor the model articles of association provide the right of pre-emption on the transfer of existing shares. Consequently, under the model articles, shareholders are free to sell or gift their shares to any person of their choosing. This includes family members, other shareholders in the company, and external investors.
Whilst share transfers require the approval of the company directors, members are under no legal obligation to first offer their available shares on a pro-rata basis to the other members of the company. This can be problematic and lead to shareholder disputes.
To avoid such issues, many companies provide enhanced pre-emption rights in amended or bespoke articles and a shareholders’ agreement. Doing so ensures better protection for all shareholders and the company as a whole. To change the articles or agreement, the members must pass a special resolution at a general meeting or in writing.
Enhanced pre-emption rights and restrictions
Some of the most common types of pre-emption rights and restrictions that companies may include in one or both of these documents include the following:
- Shares available for transfer must be first offered to existing shareholders before anyone outside the company
- A specified class of shareholders has first refusal on the allotment of new shares
- Restricting the transfer of shares to only existing shareholders’ family members (e.g., spouses or children). This is commonplace in small family-run companies
- Members can freely transfer all or a limited percentage of their shareholdings to family members
- Restrictions on the transmission of shares upon the death of a shareholder (e.g. that their shares must first be offered to the surviving members, or specified surviving members)
- Right of pre-emption on the allotment or transfer of shares applies only to holders of certain classes of shares (e.g. ordinary shares, but not preference shares)
- Application or disapplication of rights applies only on the issue or transfer of a specified class of share (e.g. preference shares)
- Dissapplication of pre-emption rights on the buy-back of shares (i.e. when a company purchases its own shares from a shareholder)
Companies may also specify procedures for offering available shares to existing members that differ from the statutory procedure in the Companies Act. For example, how pre-emption offers are communicated and the time limit for accepting the offer.
Pre-emption rights are one of the most common features in bespoke articles and shareholders’ agreements, highlighting their importance in a company with two or more shareholders.
The articles and shareholders’ agreement must be properly drafted to reflect the needs of the company and protect all members’ interests. If they include pre-emption rights, the provisions in both documents must be identical.
Waiving pre-emption rights
Shareholders can waive their statutory or enhanced pre-emption rights on a case-by-case basis and refuse an offer to buy shares that become available through an allotment or transfer. Doing so has no impact on their ability to take up any future offer of shares.
Similarly, unless the articles or shareholders’ agreement contains provisions to the contrary, the company can disapply pre-emption rights in certain situations by passing a board resolution or a special resolution of the members. Companies may choose to do this to raise capital from third-party investors.
Alternatively, members can pass a resolution to amend the articles and/or shareholders’ agreement to permanently remove all rights of pre-emption. However, this can have negative consequences, not least for minority shareholders.
Disadvantages of pre-emption rights
Whilst pre-emption rights afford existing shareholders greater protection and control over their interests and the business, certain disadvantages must be considered.
The right of first refusal puts restrictions on the freedom of shareholders to transfer their shares to parties of their choosing. It can also limit a company’s ability to raise capital from external investors as a means of growing the business.
Moreover, the requirement to offer available shares to every shareholder can be time-consuming and expensive in companies with multiple members. This can delay fundraising efforts or the exit of a shareholder who wishes to leave the company.
Wrapping up
If you are setting up a company with at least one other shareholder, you should carefully consider pre-emption rights and the level of protection you wish to provide for yourself, other members, and the company.
Statutory pre-emption rights may be suitable for some companies. However, it is often more beneficial to include additional rights in amended or bespoke articles and a shareholders’ agreement.
This will prevent the involuntary dilution of members’ profit entitlement and voting rights upon the allotment of shares. It will also help preserve the status quo of the company’s membership by restricting the ability of unsuitable third parties to become shareholders.
Pre-emption rights can be incredibly complex. Therefore, we advise speaking to a solicitor to establish which rights are best for your company.
Please comment below if you have any questions about this topic or need help setting up a company. You can also contact our company formation team online or by telephone.
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