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What are pre-emptive rights?

Preemptive rights provide shareholders an opportunity to buy additional shares of the company in the future before they are offered to new investors.

A letter for waiver of shareholders’ preemptive rights ensures that preemptive rights have been forfeited by an existing shareholder.

This assures the new investors they will be able to purchase the shares about to be issued.

Shareholders often benefit from pre-emption rights, which grant them the first refusal when new shares are issued by the company. When shareholders possess pre-emption rights, they hold an advantage over other potential investors when new shares are initially offered to them.

This implies that new shares cannot be offered to others without being extended to the existing shareholders. Whenever a company issues new shares, it must ascertain whether pre-emptive rights are in place.

Shares are typically offered in proportion to their current shareholding. 

For instance, if a shareholder owns 25% of the shares currently issued, they are entitled to a first refusal right over 25% of any new shares being issued.

When an existing shareholder opts to acquire these rights, they can maintain their percentage shareholding within the company. This article explores pre-emptive rights, their types, benefits, and other associated concepts.

Shareholders may also

Example of pre-emptive rights

Consider a company’s Initial Public Offering consisting of 1000 shares. An individual purchases 100 of these shares, equating to a 10% equity interest. Subsequently, the company offers an additional 5000 shares.

A shareholder with pre-emptive rights can purchase a sufficient number of shares to protect their 10% equity stake in the company. Assuming the issues are priced similarly, this would mean acquiring 500 shares.

Types of pre-emptive rights

Pre-emptive rights in a contract can take one of two forms: the weighted average provision or the ratchet-based provision.

  • Weighted average provision: This allows the shareholder to buy additional shares at a price that reflects both the original and new share prices. The weighted average price can be calculated using either the narrow or broad-based weighted average.
  • Ratchet-based provision: This provision enables shareholders to convert preferred shares to new shares at the lowest sale price of the new issue. If the new shares are priced lower to maintain the same level of ownership, the shareholder receives a more significant number of shares.

How can pre-emption rights arise?

Pre-emption rights can originate from three sources:

  • Statutory pre-emption rights: Provided under the Companies Act 2006 in sections 561 to 576. These rights automatically apply to equity securities where dividends vary according to the company’s profits, and there is no special right to capital repayment upon the company’s winding up. Exceptions include:
  • Within the articles of association of a company: Statutory pre-emption rights can be altered or disapplied by a company’s articles of association, which then take precedence.
  • Under a shareholder’s agreement.

What procedure is followed to issue shares if pre-emption rights exist?

If pre-emption rights exist, a company has two options: follow a specified procedure to honour pre-emptive rights or bypass them.

Typically, when offering new shares, the company opts for allowing existing shareholders to purchase shares first, granting them the right of first refusal, as discussed earlier. Even if the existing shareholders decline the new shares, a procedure must still be followed.

Where pre-emption rights are specified in the articles of association, these documents should also outline the procedure to be followed. However, the most common approach is to send a rights letter to existing shareholders to apply for the shares, who can then accept the offer through an application letter.

If the rights are statute-based, a minimum of 21 days must be provided to accept the offer. A minimum acceptance period may be defined for rights specified in the articles of association.

How can the company remove pre-emption rights?

Directors might circumvent the pre-emption procedure, which can be lengthy, costly, and cumbersome. Pre-emption rights can be permanently removed by a private company amending its articles to either eliminate an explicit provision or state that statutory pre-emption rights do not apply to the company’s shares.

Both private and public companies can disapprove pre-emption rights for a specific allotment, provided a special resolution is passed by shareholders at a general meeting, accompanied by a directors’ written statement outlining the rationale, the allotment’s financial terms, and the justification for these terms.

Typically, the resolution sets both a time and a limit on the amount (or value) of shares that can be issued unconditionally, balancing the directors’ need to allot new shares with the shareholders’ need to retain some control over the share issuance.

What are the benefits of pre-emptive rights?

Preemptive rights primarily benefit investors with a significant stake in the company, enabling them to participate in its decision-making process. This can be particularly valuable for early investors and company insiders, who may be concerned about their fractional shareholding percentage among millions of outstanding shares.

  • The benefit to shareholders: Preemptive rights protect shareholders’ voting power, as the issuance of more shares can dilute company ownership. Shareholders also benefit from insider pricing for new issue shares, which potentially offers a strong profit incentive.
  • Reducing losses through preferred stock conversion
  • The benefit to companies: For new ventures, pre-emptive rights serve as an additional incentive for early investors and offer benefits to the awarding company. It is generally less costly to sell further shares to current shareholders than to issue new shares on a public exchange, lowering the company’s cost of equity and capital and potentially increasing the firm’s value.

An additional incentive for companies is the motivation to perform well and issue new stock rounds at higher prices.

Importance of checking pre-emption in new share issues

Checking for pre-emption rights is crucial to ensure that your shareholding in a company is not diluted without your consent. It also facilitates familiarity with other shareholders, which can be particularly important in scenarios where there are no pre-emption rights on transfer. 

This can potentially lead to unfamiliar individuals becoming co-shareholders. While this may be fine, understanding with whom you are in business is generally preferable.

What is the difference between an investment agreement and a shareholders agreement?

The distinction between an investment agreement and a shareholders agreement is significant in the context of corporate governance and the management of business entities.

Both types of agreements play critical roles in defining the relationships among investors, shareholders, and the company itself, but they serve different purposes and address various aspects of these relationships.

Investment Agreement

An investment agreement, often called a subscription agreement, is primarily a contract between the company and its investors. This agreement outlines the terms and conditions under which the investors will invest in the company. Key components of an investment agreement include:

  • Investment Terms: The amount being invested, the type of shares or securities being issued (such as common shares, preferred shares, or convertible notes), and the company’s valuation at the time of investment.
  • Conditions Precedent: Any conditions that must be met before the investment is completed, such as regulatory approvals or the completion of due diligence.
  • Representations and Warranties: Statements made by both the company and the investors regarding the accuracy of information provided, compliance with laws, and other assurances.
  • Covenants: Obligations undertaken by the company, such as how the investment will be used, ongoing reporting requirements, and other operational commitments.
  • Exit Strategies: Provisions outlining how investors can exit their investment, including rights of first refusal, tag-along and drag-along rights, and scenarios under which the company can buy back shares.
  • Share Vesting: Understanding the nuances of a share vesting agreement is crucial for investors and the company, as these agreements dictate the timeline and conditions under which equity is earned.

An investment agreement is typically used when new investors are introduced to the company. It details the specific terms of their investment and the mechanics of how it will be executed.

Shareholders’ Agreement

On the other hand, a shareholders’ agreement is an arrangement among a company’s shareholders. It supplements the company’s articles of association by setting out the rights and obligations of shareholders, the management and operational aspects of the company, and procedures for resolving disputes among shareholders.

Critical elements of a shareholders’ agreement include:

  • Governance and Voting Rights: How decisions are made within the company, including allocating voting rights and establishing quorums for meetings.
  • Share Transfer Restrictions: Conditions under which shares can be transferred, including pre-emption rights and processes for selling or transferring shares among existing shareholders or third parties.
  • Protection of Minority Shareholders: Provisions to protect the interests of minority shareholders, such as requiring supermajority votes for certain decisions.
  • Dividend Policies: Guidelines on how and when dividends will be distributed to shareholders.
  • Conflict Resolution: Mechanisms for resolving disputes among shareholders or between shareholders and the company.

Unlike an investment agreement, a shareholders’ agreement focuses on the ongoing relationship among shareholders and the company’s governance. It is designed to ensure that the rights and responsibilities of all shareholders, both majority and minority, are clearly defined and protected.

What is a waiver of preemptive rights?

A letter for waiver of shareholders’ preemptive rights is a binding statement by the shareholders that they wish to forfeit their right of preemption, effectively stating that they do not intend to take part in the purchase of additional shares. After the removal of preemptive rights, shareholders won’t be able to add more shares to their portfolio whenever a company issues a greater number of shares again in the future.

For example: Let say a company issued 1000 units of Initial Public Offering (IPO) and an individual purchased 10 units of that IPO, which comprises 1% of the total shares.

Now after a certain time, if the same company issued 1500 more shares in the market, a shareholder with preemptive rights can purchase additional 15 shares (which is 1 % of the total shares issued) to maintain his/her percentage of share ownership. 

The shareholders who exercise a preemptive right could purchase these additional shares, in which case they will have (10+15=25 shares), i.e.; 1% of the shareholding in the company. But those who have signed the waiver will still have only 10 shares, i.e.; 0.4% of the shareholding in the company.

What are the types of preemptive rights?

There are two types of preemptive rights. I.e.; the weighted average provision or rachet-based provision.

  1. Weighted average provision: Under this provision, a shareholder can buy additional shares at a price adjusted to take into account the difference between the original and new price of the shares (price of original shares – price of new shares).
  2. Ratchet-based provision: Under this provision, if the price of newly issued shares is less than the old one, then a shareholder is compensated with a greater number of shares to match their percentage of ownership in the company.

How do you waive pre-emption rights?

Pre-emption right on an issue can be waived by a company’s articles of association. It can be waived with a special resolution. The resolution will have to be signed by holders of at least 75% of the company’s issued shares. When this threshold is met, the pre-emption right is waived. However, these kinds of waivers only apply to shares specified in the particular resolution. For blanket waivers’, an amendment needs to be made in the articles of association.

Use a Zegal template to create a waiver of pre-emption rights now.

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