Introduction
In the intricate world of private companies, safeguarding the investments and interests of shareholders is paramount. One such protective measure is the right of pre-emption, also known as the right of first refusal. This corporate mechanism empowers existing shareholders by granting them the opportunity to acquire shares being sold by fellow shareholders before they are offered to outside third parties. Similarly, it allows them to subscribe to new shares before they are issued to external subscribers.
This article covers the general usage, mechanics, and exceptions of pre-emption rights, highlighting their significance in maintaining the equilibrium and control within a private company.By understanding the practical applications of these rights, we hope that our clients can better appreciate how pre-emption serves as a powerful tool to protect their investments, prevent dilution, and regulate share transfers.
Key Points:
- General Usage: Pre-emption rights are crucial for regulating share transfers and restricting the issuance of new shares to third parties.
- Mechanics: The straightforward process allows shareholders to maintain control, manage newcomers, and safeguard against dilution.
- Share Sale and Issuance: Detailed explanations on how pre-emption rights apply to share sales and new share issuances.
- Exceptions: Common exceptions to the right of pre-emption and their implications.
- Shareholders’ Agreements: The role of shareholders’ agreements in governing pre-emption rights and ensuring consistency with the company’s constitutional documents.
Pre-emption: A first right of refusal for shareholders
A right of first refusal or a right of pre-emption, gives existing shareholders (or a class of existing shareholders) the right to acquire the shares being sold in the company by the selling existing shareholder before they are offered to outside third party buyers, or the issuance of new shares to outside third party subscribers without giving the existing shareholders a chance to subscribe for them first.
General Usage
Pre-emptions are useful in two distinct situations:
- A private company to regulate transfers between shareholders and outside third party potential buyers
- restricting the company’s ability to issue shares to outside third party subscribers without offering the shares to existing shareholders first.
Rights of pre-emption is an effective corporate tool and are used in private company structures where there is a desire to protect the monetary value of the time and effort, or money that existing shareholders have put into the company.
Mechanics of a Right of First Refusal
The mechanics of the pre-emption are simple and allow existing shareholders to: (a) keep the shares under the firm control of the existing shareholders (b) restrict or at least manage external “newcomers” as equity holders and (c) serve as a protection against dilution.
Share Sale
Generally where an existing shareholder has found an external third party buyer, it may not sell its shares directly to that buyer without first offering the sale shares to the other existing shareholders. It is usual, subject to the terms of their arrangement, that the existing shareholders will have a fixed period within which to respond and offer to purchase the sale shares. Normally existing shareholders can participate pro-rata in the sale in accordance with their percentage share of the company, or they make take up more if some of the other existing shareholders decide not to participate. Sometimes the company itself may intervene in the sale if necessary and use the company’s balance sheet to buy back the shares. In the end the balance may be sold to the outside third party buyer. For the sake of the company and the participants, the price of the shares is usually prescribed to be the same for all, but this may vary under the terms of the pre-emption by contract.
Share Issuance
The same process operates where the company wishes to fundraise by issuing more shares. The existing shareholders may be given a right to subscribe for their pro-rata share and so on, before the outside third party gets a look in.
Exceptions
There are usually some exceptions to the right of pre-emption on the sale of some shares. In particular, unless specifically prohibited they usually don’t apply on the allotment of:
- bonus shares, or
- shares wholly or partly paid up otherwise than in cash, or
- shares issued pursuant to an employees’ incentive share plan, or
- shares taken by the subscribers to the Memorandum of Association of the company on incorporation.
Some countries have a model pre-emption in their companies laws. There are normally powers under legislation in these jurisdictions to disapply the right in certain circumstances. Usually parties disapply the sections either in order to replace the statutory provisions with contractually enforced provisions or, to include shareholders own preferences in the form of a shareholders’ agreement, or they wish to do away with the model pre-emption provisions contained in the companies legislation all together.
Shareholders’ Agreements
Where the choice is to use a shareholders’ agreement to govern the terms of a right of pre-emption or first refusal, this agreement is made between the shareholders and the company. The terms of the shareholders’ agreement should be enshrined in the company’s constitutional documents (memorandum and articles of association) to ensure that there are no conflicting provisions, and that the terms of the shareholders’ agreement are also enforceable at company level by the directors’ (and on them) by the shareholders.
A shareholders’ agreement might contain more specifics on how the pre-emption right will work in practice. For example, a shareholders’ agreement might restrict the transfer of shares to only a certain class of shareholders in the company, or restrict the timing of the transfer, or may exclude certain types or classes of outside third party buyers or subscribers. This might be the case in a family run company where only family members are allowed to be shareholders.
Pre-emption rights can be complex, and can be detrimental to a shareholder in a private company trying to exit. It might also complicate the process of raising capital or bringing in strategic partners once the business has started to expand. Selling at a price that is reflective of the current value might also become difficult given that sales may be of a minority stake, or for strategic or non-cash consideration.
We hope this article serves as a useful resource for understanding how pre-emption rights can be strategically employed to protect and enhance their shareholder interests in a private company setting.
Marbury’s team has real practical expertise at advising clients. We listen and ask relevant questions to understand your needs so that we can ensure your interests are clearly covered in company documentation. For assistance or further information, please contact your usual Marbury relationship manager or info@marburys.com.
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