Shareholder Pre-emptive Rights
By Joanne Hue, Last updated: 2022-11-29 (originally published on 2022-03-10)
What Are Pre-emption Rights?
Shareholders of a company usually benefit from the pre-emption rights which give them a right to the first refusal when new shares are issued by the company. Where the shareholders have pre-emption rights, they have an advantage over other potential investors because new shares are first offered to them.
This means that the new shares can’t be offered to others without first being offered to the current shareholders. Whenever new shares are issued by any company, it needs to check whether pre-emptive rights exist or not.
These shares are generally offered in proportion to their current shareholding. It means that if any shareholder who owns 25% of shares in issue has a pre-emption right then he will get the first right of refusal over 25% of any new shares to be issued.
Where an existing shareholder chooses to acquire these rights, they will be able to maintain their percentage shareholding in the company. This article discusses pre-emptive rights, their types, benefits, and other related concepts.
Example of Pre-emptive Rights
A company’s Initial Public offering consists of 1000 shares and when a person buys 100 of these shares, it is 10% equity interest in the company. Going further, additional 5000 shares are offered by the company.
A shareholder who has a pre-emptive right will get an opportunity to buy as many shares in order to protect his 10% equity stake in the company. It would be 500 considering that both the issues were at the same price.
Types of Pre-emptive Rights
There may be either of the two types of preemptive rights offered in a contract, the weighted average provision or the ratchet-based provision.
- Weighted average provision: the shareholder will be able to buy additional shares at a price which is adjusted for the difference between the price paid for the original shares and the price of the new shares. The weighted average price can be calculated in the two ways: narrow-based weighted average and the broad-based weighted average.
- Ratchet-based provision: it gives an option to shareholders to convert preferred shares to new shares at the lowest sale price of the new issue. Where new shares of a company are priced lower, in order to maintain the same level of ownership, the shareholder is compensated with a greater number of shares.
How can Pre-emption rights arise?
There are three sources from which the pre-emption rights can arise:
- Statutory pre-emption rights: given under the Companies Act 2006 in section 561 to 576. By default, these apply to equity securities where the dividend paid varies according to the company’s profits and there is no special right to capital repayment in the event of winding up of the company. Such provisions don’t apply to the following:
- Shares held under an employee share scheme.
- Shares issued partly or wholly for non-cash consideration.
- Bonus share issues.
- Within the articles of association of a company: where the statutory pre-emption rights would otherwise apply, these can be altered or disapplied by a company’s articles of association. The provisions in the articles take precedence.
- Under a shareholder’s agreement.
What procedure needs to be followed to issue shares if pre-emption rights exist?
If shareholder pre-emption rights exist, there are two choices for the company, either to follow a specified procedure to consider pre-emptive rights or prevent the pre-emption rights from applying.
Generally, when offering new shares for sale, the company chooses to follow the procedure which allows the existing shareholders to first purchase the shares prior to offering them to potential investors. This gives the current shareholders the right of first refusal as discussed above. A procedure still needs to be followed even when the existing shareholders don’t want the new shares.
Where the pre-emption rights are defined in the articles of association, the articles should also define the procedure to be followed. However, the most widely used procedure is to send a letter of rights to the existing shareholders to apply for the shares. The shareholders can accept the offer via a letter of application.
In case those pre-emption rights are defined in the statute, a period of at least 21 days must be given to accept the offer. In the case of rights defined in the articles of association, a minimum time period may be specified for the shareholders to accept the offer.
How can the company remove pre-emption rights?
The directors may prefer not to follow the prescribed pre-emption procedure, which can be time-consuming, expensive, and cumbersome. The company may remove the pre-emption rights by allowing the new investors to take the shares more flexibly. The pre-emption rights may be disapplied permanently by a private company by amending its articles by either removing an explicit provision in the articles themselves or stating that the statutory pre-emption rights are not to apply to the company’s shares.
Private and public companies can instead disapply pre-emption rights for a specific allotment, provided a special resolution has been passed by the shareholders at a general meeting and a written statement by the directors. This has to be accompanied by the notice of the meeting to propose the special resolution in which they give the reasons for making the recommendation, the amount to be paid to the company in respect of the allotment and the directors’ justification of that amount.
Generally, the resolution will impose both a time limit and a limit on the amount (or value) of shares that can be issued unconditionally. This balances the need for the directors to have the freedom to allot new shares with the members’ as needed to retain some control over the number of shares issued.
What are the benefits of Pre-emptive Rights?
Pre-emptive rights are beneficial mainly to investors who have a large stake in the company and have a right to take part in the decision-making process of the company. In some cases, a large stake is acquired by a few investors to raise any concerns about a reduction in the fractional percentage that their shares represent among millions of shares outstanding. Early investors and company insiders are most likely to benefit from it.
- The Benefit to Shareholders: Preemptive rights protect the voting power of shareholders because when more shares are issued, the ownership of the company becomes diluted. As a shareholder gets an insider’s price for shares in the new issue, there can also be a strong profit incentive.
In a worse-case scenario, by converting the preferred stock to more share options the losses may be reduced if the new issue is priced lower.
The Benefit to Companies: In a new venture, the pre-emptive rights work as an additional incentive to early investors but they have additional benefits for the company that awards them. It doesn’t involve much cost to sell additional shares to the current shareholders than to issue additional shares on a public exchange.
Hence, it is less expensive for the company. The company has to pay an investment banking service to manage the sale of the shares when issuing stock to the public. Selling it to the existing shareholders lowers the company’s cost of equity, and hence its cost of capital which in turn increases the firm’s value.
An additional incentive offered by the pre-emptive rights to a company is to perform well so it can issue a new round of stock at a higher price.
Why is it important to check if there is pre-emption, on new share issues as well as on?
It is important to do so because that will help ensure that your shareholding in a company is not weakened without your say. It will allow you to get to know other shareholders in the company. Also,
If you hold shares in a company and there are no pre-emption rights on transfer, it could get tricky as you may find yourself in a company with complete strangers. While this might not be as bad as it sounds, it is something quite tricky in business as you are not aware of who you are in business with.