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Pre-emptive rights are a right of first refusal for existing shareholders where new shares are being issued or a fellow shareholder wishes to sell their shares. These rights are very common in startups and companies in general. The existence of shareholders’ pre-emptive rights will affect the process by which your startup can issue shares. They will also affect how company shareholders can sell shares. Therefore, it is important to understand what they are and how they can impact your startup. This article will explore:
- what pre-emptive rights are;
- when and why shareholders will have these rights;
- how to identify the rights that apply to your startup; and
- what they mean for your startup and shareholders.
What are Pre-Emptive Rights?
Pre-emptive rights allow shareholders to subscribe for new shares or purchase existing shares before any third parties.
When your shareholders have pre-emptive rights to:
- the issue of new shares, they can subscribe for those shares before your company can offer them to third parties; or
- the transfer of shares, they can purchase shares that another shareholder is selling before that shareholder can offer them to third parties.
If all shareholders elect to take up their pre-emptive rights, they are allocated the number of shares that reflect their ownership proportion of the company. If only some shareholders elect to take up their pre-emptive rights, then any remaining unallocated shares are generally either re-offered to participating shareholders or offered to a third party. This approach prevents one shareholder from buying or subscribing to all the shares available and unfairly increasing their shareholding ahead of the other shareholders.
An Example
For example, you hold 10% of a company, and the company wants to issue an additional 20,000 shares at a price of $5.00 per share. Assuming all the other shareholders take up their pre-emptive rights, you would have the right to invest in an additional 10% of those 20,000 shares (or $10,000 for 2,000).
Similarly, if you were selling 100 shares, an existing shareholder with a 10% ownership stake can purchase 10 of your shares.
In either scenario, the shareholder with the pre-emptive right has no obligation to subscribe to or buy the entire 10%. Likewise, shares not taken up by the shareholder will be offered to the others or third parties.
Why Do Companies Give Shareholders Pre-Emptive Rights?
Avoiding Dilution of Investment
Pre-emptive rights enable shareholders to avoid diluting their investment when new shares are issued.
Here is a common situation for a startup: It reaches a stage of growth where it needs to raise capital through the issue of new shares. That issue means that existing shareholders will end up with a smaller ownership percentage of the company if the shares are sold to third parties. As one of the shareholders, you might want to avoid dilution (and have the means to do so), so you invest more money in the company for more shares by using your pre-emptive rights. This allows you (and other shareholders) to maintain the same, or grow, your ownership percentage of the company.
Avoiding Dilution of Control
Additionally, dilution of investment may equal dilution of control. For example, you may own 80% of your startup and, as a result, can make many key decisions concerning the company without requiring approval from other shareholders. After a proposed share issue that you do not take part in, your shareholding could be diluted to, say, 40%. This might mean that you have far less control over key decisions that are made in relation to your startup. Utilising your pre-emptive rights is one way to maintain your shareholding and control.
Protecting Shareholder Interests
Pre-emptive rights on a transfer of shares also protect existing shareholders by allowing them to purchase a selling shareholder’s shares before third parties. It, therefore, allows them to increase their ownership interest while also preventing unknown external parties from becoming shareholders in the company.
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Other Considerations
Pre-emptive rights can also benefit your startup. If some or all of your existing shareholders can contribute further capital to the company, this is usually a cheaper and more efficient process than looking for external investors.
Despite the benefits noted, it is not always feasible for a shareholder to utilise their pre-emptive rights. You might, for example, not have any spare cash to put into the business at the required time. Control in relation to a startup is, therefore, best dealt with in a shareholders’ agreement. In particular, you can include provisions embedding the rights of founders (and other key shareholders) to continue having a say in key company decisions for as long as they remain a shareholder, regardless of their shareholding percentage.
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How Do You Know if Your Shareholders Have Pre-Emptive Rights?
It is essential to check your startup’s governing documents (if any). Pre-emptive rights can apply to both the issue of new shares and the sale of existing shares. However, they will not always apply to both.
The base position is that the Companies Act includes pre-emptive rights for shareholders in relation to the issue of new shares (but not share transfers). Your company constitution or shareholders’ agreement can change the position at law, so it is very important to check whether those documents exist.
Notably, your company’s shareholders’ agreement takes precedence if you have one. You will generally find pre-emptive rights in the clauses relating to share issues and share transfers. They will refer to the company’s or selling shareholder’s requirement to offer shares to existing shareholders first.
If your company does not have a shareholders’ agreement, check your company constitution to confirm whether it addresses these rights. If your company does not have a constitution, the Companies Act rules will apply.
What is the Pre-emptive Rights Process?
If your company’s shareholders have pre-emptive rights, there will generally be a prescribed process to follow when issuing or selling shares.
Firstly, your company’s directors or selling shareholders must prepare a notice stating the terms of the issue or the sale. The notice will need to include details of the number of shares on offer and the price per share. This notice is circulated to all existing shareholders (other than the seller, in the case of a share transfer).
The existing shareholders (other than the seller in a share transfer) will have a timeframe during which they can take up the offer contained in the notice. Each shareholder wishing to subscribe for, or purchase shares, will need to tell the board in writing how many shares they wish to subscribe for or purchase. If the total number of shares taken up is greater than the total number of shares on offer, each shareholder will be allocated shares at their respective proportion. This could be less than the amount they wish to subscribe for or purchase. If the total number of shares taken up is less than the total on offer, any remaining shares are either re-offered to the participating shareholders or offered to a third party.
Key Takeaways
It is very common for shareholders to have pre-emptive rights. These rights enable shareholders to subscribe for or purchase shares in the company before they are offered to third parties. This enables a shareholder to maintain or increase their ownership stake in the company. They can also prevent unknown third parties from becoming shareholders. You should check your company’s constitution and shareholders’ agreement to determine whether shareholders have pre-emptive rights. If so, your company directors and shareholders need to follow a certain process when issuing or transferring shares.
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Frequently Asked Questions
Pre-emptive rights allow shareholders to subscribe for new shares or purchase existing shares that another shareholder sells before the shareholder offers them to any third parties.
Check your company’s governing documents to determine if your shareholders have pre-emptive rights. If your startup has a shareholders’ agreement or constitution, it will likely be covered in one or both. The Companies Act will apply if you do not have either of these documents. Accordingly, you will have pre-emptive rights in relation to the issue of new shares, but not where a shareholder is selling their shares.
These rights enable shareholders to avoid diluting their investment and control when the company issues new shares. Ultimately, this prevents their ownership percentage in the company from decreasing.
As a startup, there will be times where you need to raise capital from third parties. Where the shareholders have all agreed that they need external investment, they can waive their pre-emptive rights.
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