Understanding Pre-Emption Rights for Company Shares: Why They Matter

Protecting your stake in a company is essential, especially when changes in shareholding occur. One of the most important mechanisms for safeguarding your interests as a shareholder is pre-emption rights.

But what exactly are pre-emption rights? And why are they so crucial for both existing shareholders and the company itself? In this blog post, we’ll explain what pre-emption rights are, how they work, and why they should be included in your company's Articles of Association and Shareholder Agreements.

What Are Pre-Emption Rights?

Pre-emption rights are a legal right that gives existing shareholders the following rights:

1. on a company issuing (allotting) brand new shares, a first opportunity to purchase those new shares before those shares are offered to external buyers. These rights help maintain the proportional ownership and control that shareholders have within the company, in other words, it avoids an existing shareholder’s stake in a company becoming diluted by the creation of new shares.
   
   In simple terms, if the company decides to issue new shares (for example, to raise capital), pre-emption rights ensure that existing shareholders have the first right of refusal. They can purchase additional shares in proportion to their existing holdings, which helps them maintain their percentage of ownership and voting power.
    
2. if an existing shareholder wishes to exit the business and sell their shares in a company, they have to first offer those shares to the other shareholders before they can be sold to a third party.  This helps existing shareholders to retain control of a company and can be especially important for small and family run businesses.  

Why Are Pre-Emption Rights Important?

Pre-emption rights are critical for several reasons, both from a shareholder protection and company governance standpoint:

1. Protect Shareholder Interests - One of the most straightforward reasons for pre-emption rights is to protect the interests of existing shareholders. If new shares are issued or transferred to outsiders, the ownership and control of the company can shift. Pre-emption rights give shareholders the opportunity to maintain their level of influence and avoid the dilution of their ownership stake.
2. Maintain Control and Voting Power - For shareholders who are active in the management and direction of the company, maintaining control is often a top priority. Pre-emption rights ensure that the shareholders who helped build the business can keep their voting power intact. Without pre-emption rights, a new investor could come in and gain significant influence, altering the balance of power within the company.
3. Control Over Who Becomes a Shareholder - Pre-emption rights also allow shareholders to control who joins the company’s shareholder base. Without these rights, a shareholder could sell their shares to a competitor, a person with conflicting interests, or an external party that could cause disruptions. Pre-emption rights allow existing shareholders to approve (or block) the entry of a new shareholder.
4. Encourage Investment Stability - When shareholders know they have pre-emption rights, they may feel more confident in investing further in the company. They can rest assured that their ownership and influence won’t be diluted unless they choose to sell or buy more shares themselves.

How Do Pre-Emption Rights Work?

Pre-emption rights work in a similar way regardless of whether we are talking about the creation of new shares or the transfer of existing shares. Here’s how it works step by step:

1.       Either... 
a) a company decides to raise additional capital by issuing new shares. Before these shares can be sold to external investors, the existing shareholders must be offered the chance to purchase them or 
b) an existing shareholder wishes to exit the business and offers some or all of their shares for sale.

2.       Offer to Existing Shareholders: 
The company or existing shareholder (as applicable) notifies its shareholders of the number of new shares being issued or number of existing shares to be sold, and they are given the right to buy shares in proportion to their current holdings if there is more than one shareholder. For example, if a shareholder owns 10% of the company, they have the right to purchase 10% of the newly issued shares/shares to be transferred.

3.       Decision by Shareholders: 
Existing shareholders can either choose to exercise their pre-emption rights and buy the new shares/existing shares or decide not to participate. If they choose not to buy, the company or the exiting shareholder can then offer the remaining shares to outside investors.

Types of Pre-Emption Rights

There are two main types of pre-emption rights:

1. Statutory Pre-Emption Rights: Under the Companies Act 2006, shareholders in private companies have the statutory right to buy new shares issued by the company. This can only be waived or modified if the shareholders agree to do so.
    
2. Contractual Pre-Emption Rights: These are rights that are set out in a company’s shareholders agreement or articles of association. They may provide more specific or tailored conditions for when pre-emption rights apply, such as certain restrictions on share transfers or rights for existing shareholders to match third-party offers.

When Can Pre-Emption Rights Be Waived?

While pre-emption rights are common, they can be waived or adjusted under certain circumstances:

1. Shareholder Agreement Provisions: In some cases, a company’s Shareholders Agreement may allow the waiver of pre-emption rights, either partially or fully, under specific conditions. This could happen if there’s a particular need for an external investor, or if all shareholders agree to waive their rights.  Family run businesses often contain very specific provisions about when shares can be transferred and to whom.
    
2. Investor Negotiations: Sometimes, external investors or venture capitalists may negotiate to have pre-emption rights waived or altered in favor of more flexibility in their investment.
    
3. Special Circumstances: In some cases, pre-emption rights may not apply if shares are being issued as part of a merger or acquisition, or in situations where the company needs to raise emergency funding quickly.

Pre-Emption Rights and the Shareholders Agreement

A Shareholders Agreement is the best place to define the terms and conditions of pre-emption rights. The agreement can specify the procedure for offering new shares to existing shareholders, the timeframe for exercising rights, and consequences if rights are waived. By clearly outlining the pre-emption rights in the agreement, it ensures that all shareholders understand their options and the rules for future share issuance.

A company’s Articles of Association will also set out pre-emption rights to entrench these rights and bind them upon the company.

Conclusion: Protecting Your Interests with Pre-Emption Rights

Pre-emption rights are a powerful tool for maintaining control and protecting your investment in a company. They help shareholders maintain their proportional ownership and ensure that any new shares issued of a sale of existing shares are offered first to those who are already involved in the company.

For business owners and investors, having pre-emption rights in place can offer peace of mind and a clear process for dealing with future changes in shareholding. If you’re starting a company or reviewing your existing Shareholder Agreements, it’s crucial to consult with legal professionals to ensure your pre-emption rights are properly defined and legally sound.