A Guide to Understanding Pre-emption Rights in a Private Limited Company

Private Limited Companies within the UK issue shares to shareholders. When new shares are offered by a company or when there are transfer of shares, existing company shareholders have some certain right over these shares. Usually, the current shareholders of the company have the opportunity to take the new shares before they can be offered to outside investors.

The rights that are available to shareholders when there is allotment of new shares or transfer of shares within a company before a third party is considered are called preemptive rights.

Preemption rights are usually contained in the Company Act 2006, Article of Association and the Shareholder Agreement. These rights are essential as they help protect shareholder's ownership, their profits entitlement, voting rights and so on. In this guide, you will learn all you need to know about preemption rights in a private limited company.

What are Pre-emption Rights?

Preemption rights are the rights of first refusal available to shareholders or members of a company when there is allotment or transfer of shares within the company. These rights are there to protect the interest of the shareholders of the company when it comes to shareholdings. As such when a company provides the preemption right, every existing shareholder or member of the company is given the right and opportunity to purchase a new share that is available within the company before the share can be introduced to an outside investor.

Apart from that preemption right helps ensure that the shareholdings of current shareholders are not unnecessarily diluted as they have the right to object to the transfer of their shares thereby preventing dilution.

Dilution of member’s shares within the company reduces their ownership stake, voting rights, and profits. So following a preemption right could help avoid involuntary dilution of shares within the company. Every private limited company therefore must take note of the preemptive rights that are within the company before allocating new shares. These rights most times are usually in proportion to the current shareholdings of all existing shareholders.

Where are Preemption Rights Situated?

Preemption rights are made available in the Company Act 2006, Articles of Association and the Shareholders Agreement. It is therefore essential that these documents are checked through before there is allotment or transfer of shares.

1. Company Act 2006

Statutory preemption rights are provided in sections 561-577 of the Companies Act 2006. The statutory preemption right available according to this legislation can only be applied to ordinary shares. As such there are no preemption rights for shareholders for the transfer of shares or the allotment of new shares apart from the ordinary shares. However, many companies choose to make some changes to this in their Article of Association.

2. Article of Association

The statutory preemption right doesn’t make provisions for the transfer of shares and the allotment of shares apart from the ordinary shares. So many companies have made amendments to this in the Articles of Association. It is also recommended that any company with just one shareholder should allot new shares to investors and transfer shares if needed in the future. Apart from that making amendments to the statutory preemption right gives the chance for the company to consider the interest of shareholders when allotting new shares and when transferring shares.

3. Shareholder Agreement

Apart from the Company Act 2006 and the Articles of Association, the shareholder agreement is another document to consider when transferring shares or allotting new ones within the company. The shareholder agreement should highlight important details about company allocation and it should be in accordance with what is in the Article of Association. Importantly the provisions on the preemption right available in the shareholder agreement should not contradict what is in the Article of Association to avoid confusion.

Do all Shareholders have Preemption Rights?

According to the Companies Act 2006, shareholders of a private limited company have the preemption right when new shares are being allotted. However, this might not be applied to the transfer of shares. So if a company intends to offer a new share, the shareholders of the company must be made aware before any other outside investors. With that, the company could communicate to the shareholders through paper or electronic form giving them at least 14 days for them to accept the share offer.

The statutory preemption right will thus be applied on all allocation of new shares except in situations where the company has agreed not to use the right for a specific share allotment or where the company has removed the preemption rights from the Article of Association and the shareholder's agreement. However, for this to happen, a special resolution must be passed. To then pass a special resolution at least 75% of the voting members must vote in support of the motion.

Apart from the statutory preemption rights, many private limited companies have their preemption rights contained in the Articles of Association and the shareholder agreement. This is to ensure that all shareholders of the company are being protected. So in most cases, even when the transfer of shares occurs, these two vital documents will be referred to.

Exceptions to Statutory Preemption Right

Statutory Preemption right is applicable whenever there is an allotment of new shares within a company. However, there are some situations where they may not apply as shown below.

• When there is an allocation of bonus share
• When a share is issued for the employee share scheme purpose.
• When a company is in financial distress and the allotment of shares is agreed upon by the company and the creditors.
• When shareholders waive their right to take new shares.

Waiving Preemption Rights by Shareholders

While shareholders have the right or opportunity to be allotted new shares within the company, they also have the chance to waive the preemption rights. This simply means when new shares are available within the company or when the company is about to transfer shares, shareholders can waive their right to receive the shares. With that, when they waive the right for a particular allotment, it doesn’t affect their ability to use the preemption right and get new shares when it’s available in the future.

Also in some cases, a company may pass a special resolution or board resolution to ignore the preemption rights. So a conclusion must be reached by the shareholders and if it is in favor of waiving the preemption rights, it will done accordingly. However, for a company to apply a special or board resolution in order to not apply a preemption right, there must not be an objection to this in what they have in the Articles of Association and the shareholder's agreement. Most companies do this when they wish to raise capital from an investor and so the shareholders must come together and reach a conclusion before it can be done.

What are the Procedures to Take on Statutory Preemption Rights?

The procedure companies take when it comes to allotting or transferring shares will depend on whether the company is applying statutory preemption rights or the amended ones in the Articles of Association and Shareholder agreement. Directors must therefore refer to the preemption rights available within the company before issuing or transferring shares to ensure that the right procedure is taken.

If the company is applying the statutory preemption rights, then the director of the company is expected to contact the current company shareholder and offer the issuing of shares based on the share proportion they currently have. So for instance, if a shareholder currently owns 15% shareholdings within the company, they will be offered 15% of the newly allotted shares. This must be done before the company can allot any share to any outside investor. When the shareholders receive a notice of this offer, they will have to choose either of the options below:

• Purchase the newly allotted share offered
• Make a decline on the offer by notifying the company of their intent to waive their preemption rights on the particular share offer.
• Pass a special resolution so that the preemption rights of all current shareholders can be waived on the allotted share.

So in cases where members waive their preemption rights, the company can then introduce the share offer to outside investors. However, the terms and conditions of the offer must not be more favourable than those offered to the company members.

In situations where the company applies the preemption rights on the Article of Association or shareholder agreement, then the procedure to follow could be different. As such the company must ensure that the article is well drafted to allow provisions for the allotment, transfer and transmission of shares. Apart from that the procedures to be followed by the shareholders must be explicitly explained.

Can I Introduce Preemption Rights in the Article of Association after Incorporation?

According to the Companies Act 2006, amendments can be made to the Articles of Association even after the company's incorporation. As such it is legal to introduce the preemption right in the article even after the company’s formation. While we have many new companies that hold on to the statutory preemption rights during the company formation, we also have many who had made adjustments or introduced their preemption right after the company was incorporated.

So for a company to make amendments to the preemption right after the company formation, a special resolution must be passed in a meeting or written form. While passing the resolution, at least 75% of the voting shares of members must be in support of the resolution. If shareholders don’t meet up with this, then the resolution cannot be passed. But once they can meet up and the resolution is passed, the company can include additional rights to the already existing preemption rights.

Can I remove Preemption Rights from the Article of Association Permanently?

Yes, a company can remove preemption rights permanently from an Article of Association. This can be achieved by passing a special resolution. With that, at least 75% of voting members must cast their vote in support of the motion. Once it’s successfully done, the preemption right can be removed from the article.

In some cases, some companies pass a special resolution when they wish to allot new shares or transfer shares without considering the preemption rights contained in the articles. So in such cases, a special resolution will be passed to allow members to vote in favor or against the motion. If at least 75% of voting members vote in favour of the motion, then the resolution will be passed. This process is usually done to avoid permanently removing preemption rights in the article. As such companies would rather pass a resolution to allow members to reach a conclusion on the particular shares that are to be newly allotted or transferred.

Advantages of Preemption Rights

Preemption rights are important in protecting the interest of the existing shareholders of a company by allowing them to accept new shares within the company when available. Apart from that, it helps prevent the dilution of members’ shares as this influences their voting rights and profits entitlement within the company. Minority shareholders especially are protected from losing all their shareholdings within the company by virtue of share transfer.

Disadvantages of Preemption Rights.

While preemption rights offer so many benefits, especially to the existing shareholders of the company, it could be detrimental in some cases.  Firstly, preemption rights restrict individual members from transferring their shares to other people outside of the company. Apart from that, it could limit the company's chances of getting more external investors since existing shareholders have the right to share before outsiders.

More so, when the new shares within the company are offered to existing shareholders, it is usually time-consuming and expensive. This could therefore delay the time in getting more funds for the company or delay a shareholder who wishes to exit a company.

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Conclusion

As a shareholder in a private limited company, apart from considering the statutory preemption rights contained in the Company Act 2006, it is important to make provisions for some additional rights in the Articles of Association and shareholder agreement. While this is not an obligation, it would prevent shareholders from involuntary dilution of shares and subsequently help maintain their ownership and voting rights. Do you have any questions about  Pre-emption Rights in a Private Limited Company? Kindly contact one of our experts here.