A Guide to Pre-emption Rights in Private Limited Companies

emily gordon brown
Emily Gordon BrownLegal Assessment Specialist @ Lawhive
Updated on 20th September 2024

Pre-emption rights are a fundamental concept in corporate law, playing a vital role in protecting the interests of shareholders in private limited companies. These rights give existing shareholders the first option to purchase new shares issued by the company, ensuring they can maintain their ownership percentage and prevent unwanted external parties from acquiring shares. In essence, pre-emption rights safeguard against dilution of ownership and voting power, providing an important layer of protection for shareholders.

This article will cover:

  • What pre-emption rights are and how they work

  • The benefits of pre-emption rights for shareholders

  • How companies can issue new shares while respecting pre-emption rights

  • How to change or cancel pre-emption rights

  • Frequently Asked questions and answers about pre-emption rights.

What Are Pre-emption Rights?

Pre-emption rights are an important protection for existing shareholders in a private limited company, giving them the first opportunity to purchase new shares issued by the company. This means that when a company issues new shares, existing shareholders have the right to buy them before anyone else can. This protection helps existing shareholders maintain their ownership percentage and control of the company, preventing dilution of their shares.

This priority access also ensures that existing shareholders can increase their stake in the company if they choose to or maintain their current level of ownership. This is particularly important for shareholders who want to ensure they don't lose control or influence over the company's direction and decision-making.

Pre-emption rights are protected by law in the UK, specifically in the Companies Act 2006. Section 561 of the Act states that companies must offer new shares to existing shareholders before offering them to anyone else unless the shareholders agree to waive this right. This means that existing shareholders have the first opportunity to buy new shares, which helps to protect their ownership and control of the company.

This protection is built into the company's rules, called the Articles of Association, which outline how the company is run and how shares are issued. The Articles of Association must comply with the pre-emption rights Companies Act 2006, ensuring that companies treat their shareholders fairly and transparently when issuing new shares.

The Companies Act 2006 provides a framework for companies to follow, ensuring that:

  • Existing shareholders are given the opportunity to purchase new shares before anyone else.

  • Shareholders are treated fairly and equally.

  • Companies are transparent in their share issuance processes.

  • Shareholders' rights are protected.

How Pre-Emption Right Works

The process of pre-emption rights is straightforward. When new shares are issued, existing shareholders are given a chance to buy them first. Here’s a breakdown of how pre-emption rights work:

Issuance of New Shares

When a private limited company wants to issue new shares, its directors must agree on the number of shares to be issued and the price per share. The company must then notify its existing shareholders of their right to purchase these new shares. This is usually done by sending a letter or email to each shareholder.

Shareholder Notification

Existing shareholders must be notified in writing of their right to purchase new shares. This notification must include details of the number of shares being issued, the price per share, and the timeframe in which shareholders must respond. Typically, shareholders have 14-28 days to decide whether to exercise their pre-emption rights.  During this time, they can choose to buy some or all of the new shares on offer.

Waiving Pre-emption Rights

To waive pre-emption rights, shareholders must sign a written resolution or agreement confirming their decision. This waiver can be for a specific share issuance or for all future issuances. By signing this document, shareholders allow the company to sell the new shares to other investors without offering them first.

Shareholders may choose to waive their pre-emption rights in certain circumstances, such as:

  • If  they don't want to invest more money in the company

  • If they're happy for new investors to join the company

  • If they're selling their shares and don't want to purchase new ones

Benefits of Pre-Emption Rights

Pre-emption rights in private companies provide shareholders with important benefits, such as protection, control, and fairness. These rights ensure that when new shares are issued, existing shareholders have the first opportunity to purchase them, helping to safeguard their stake and influence within the company. Here's how pre-emption rights work to protect your interests:

Protection Against Dilution

Pre-emption rights protect existing shareholders from losing ownership and control when new shares are issued. Existing shareholders get first priority to buy new shares, keeping their percentage ownership the same. Without pre-emption rights in private companies, protecting against share dilution is impossible and new shares could be issued to external parties, diluting existing shareholders' ownership and potentially altering the company's direction. This dilution could lead to a loss of voting power, reducing existing shareholders' influence over company decisions.

Maintaining Control

Pre-emption rights help shareholders maintain control over the company by preventing unwanted external parties from acquiring shares and gaining control. Giving existing shareholders the first opportunity to buy new shares ensures control remains with those already invested. This blocks hostile takeovers and unwanted changes to the company's strategy and keeps the company on track. As a result, existing shareholders can maintain their level of influence over company decisions.

Ensuring Fairness

Pre-emption rights ensure all shareholders are treated equally when new shares are issued. Each shareholder gets the same opportunity to buy new shares proportionate to their existing holdings. No shareholders can buy more than their fair share, preventing an unfair advantage. This fairness promotes trust among shareholders, as everyone has an equal chance to participate in the company's growth. Equal treatment ensures no shareholder can dominate the company, maintaining a balanced ownership structure.

Challenges and Limitations of Pre-Emption Rights

Pre-emption rights have downsides, too. They can be tricky to manage, cause shareholder disagreements, and slow down fundraising. Here are some of the challenges and limitations of pre-emption rights:

Administrative Burden

Managing pre-emption rights can be complicated and time-consuming, especially in larger companies with many shareholders. The administrative burden is significant, requiring careful tracking of shareholder ownership and changes, notification and communication with shareholders, and compliance with laws and regulations. This can lead to increased costs and resources dedicated to compliance, potentially diverting attention from core business activities.

Disputes Among Shareholders

Pre-emption rights can also lead to disagreements among shareholders when they disagree on whether to exercise or waive their rights. Some shareholders may want to maintain their ownership percentage, while others prefer to waive their rights and allow new investors to join. Resolving these disputes can be challenging, potentially leading to delays in decision-making, litigation and legal costs, and damage to shareholder relationships.

Impact on Fundraising

Strict adherence to pre-emption rights can complicate or delay the company's fundraising process. When new shares are issued, existing shareholders must be allowed to purchase them first. This can slow down the fundraising process, cause the company to miss opportune moments for investment, limit the company's ability to attract new investors, and hinder growth and development. Additionally, the requirement to offer shares to existing shareholders first may lead to difficulty attracting new investors, limited access to capital, and reduced competitiveness in the market.

How to Modify or Disapply Pre-emption Rights

Modifying or disapplying pre-emption rights is a significant decision that requires careful consideration of the company's goals, shareholder interests, and legal requirements. It involves altering the existing rights of shareholders to purchase new shares, which can impact ownership, control, and voting power. Companies must balance flexibility in share issuance with the need to protect shareholder rights in pre-emption and maintain transparency and fairness.

Amending the Articles of Association

Amending the articles of association is a fundamental change to the company's constitution, requiring careful consideration of the long-term implications. It's a permanent alteration that affects all shareholders and future share issuances.

Companies can change their articles of association to modify or disapply pre-emption rights by passing a special resolution. This requires that a minimum of 75% of shareholders vote in favour at a general meeting, ensuring a high level of agreement. The changes must be filed with Companies House, the UK's registrar of companies, and approved by the relevant regulatory body, such as the Financial Conduct Authority (FCA). This approach permanently alters the company's articles, affecting all future share issuances and providing long-term flexibility. Companies must ensure compliance with relevant laws and regulations, such as the Companies Act 2006 and the UK Corporate Governance Code.

Shareholder Resolutions

Shareholder resolutions offer a flexible approach to disapplying pre-emption rights, allowing companies to respond to specific circumstances while maintaining the existing rights of shareholders. This approach requires careful consideration of the short-term implications and the potential impact on shareholder relationships.

Shareholders can pass a special resolution to disapply pre-emption rights for a specific share issuance, allowing flexibility for a one-off situation. This requires at least 75% of shareholders to vote in favour at a general meeting. The resolution temporarily waives pre-emption rights, enabling the company to issue new shares without offering them to existing shareholders first. This approach is useful for specific situations, such as issuing shares to new investors or employees, while maintaining pre-emption rights for future share issuances. Companies must ensure transparency and fairness by providing clear explanations for disapplying pre-emption rights and ensuring equal treatment for all shareholders.

Navigating pre-emption rights involves several legal and regulatory steps that companies must follow to protect shareholder interests and comply with the law. The process can be complicated, but here’s what you need to know:

  1. Understanding the Legal Framework: Pre-emption rights are primarily governed by the Companies Act 2006, which protects existing shareholders by giving them the right to buy new shares before they are offered to outside parties. For listed companies, additional rules from the UK Corporate Governance Code and Listing Rules may apply, which focus on maintaining transparency and shareholder confidence.

  2. Modifying or Removing Pre-Emption Rights: If a company wants to change or remove pre-emption rights, a special resolution from the shareholders is usually required. The approval process must be documented and filed with Companies House. Failing to follow this process correctly can lead to legal disputes or loss of investor trust. Clear communication with shareholders is key, and companies should explain the potential impacts of any changes to their rights.

  3. Impact on Shareholder Control: Pre-emption rights are designed to prevent dilution of shareholder control. By allowing existing shareholders the first opportunity to purchase new shares, companies ensure that control remains with those already invested. Removing or modifying these rights can lead to a loss of voting power and ownership, so it’s important that shareholders fully understand how these changes might affect them.

  4. Seeking Legal Advice: Because pre-emption rights are closely tied to both company law and shareholder agreements, companies should seek legal counsel to ensure they remain compliant. This helps to avoid any future disputes or issues with regulatory bodies and ensures that changes to pre-emption rights are handled fairly and transparently.

FAQs 

What happens if pre-emption rights are not offered to shareholders?

If pre-emption rights are not offered to shareholders, they may lose their opportunity to purchase new shares, potentially diluting their ownership and voting power.

Can pre-emption rights be overridden by the company’s directors?

Yes, directors can override pre-emption rights in certain circumstances, such as issuing shares to new investors or employees, but this typically requires shareholder approval.

How do pre-emption rights affect minority shareholders?

Pre-emption rights protect minority shareholders by allowing them to maintain their ownership percentage and preventing the dilution of their shares.

Is it possible to reinstate pre-emption rights after they have been waived?

Yes, companies can reinstate pre-emption rights by amending their articles of association or passing a shareholder resolution.

What should I do if I want to sell my shares but retain pre-emption rights?

You should review your company's articles of association and shareholder agreement to understand how to sell shares while retaining pre-emption rights. You may need to obtain shareholder approval or follow specific procedures.

Conclusion

Pre-emption rights are important because they help protect shareholders and ensure shares are distributed fairly. They give existing shareholders the chance to buy new shares before they're offered to others, which prevents their ownership and voting power from being watered down. Companies can change or ignore pre-emption rights, but they usually need shareholder approval to do so. Shareholder agreements and company rule changes can be used to modify or ignore pre-emption rights. It's crucial to follow the law and regulations when dealing with pre-emption rights.

When it comes to pre-emption rights, there's no room for mistakes. One wrong move can lead to a loss of control over your company. At Lawhive, we connect you with seasoned solicitors who understand the intricacies of pre-emption rights in private limited companies. Whether you're issuing shares or preventing dilution, our legal experts are here to safeguard your business interests and keep you in control.

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