When investing in or managing a company, understanding shareholder rights is crucial. One such right is the pre-emptive right. These rights are designed to protect existing shareholders from unwanted dilution and ensure they have a fair opportunity to maintain their proportional ownership in a company as it grows.

In this article, we explain what pre-emptive rights are, how they operate, and their significance in corporate transactions.

What Are Pre-Emptive Rights?

Pre-emptive rights, also known as ‘rights of first refusal’, give existing shareholders the first opportunity to purchase newly issued shares or buy shares from an exiting shareholder before they are offered to external parties.

These rights are commonly found in:

1. Shareholders’ Agreements;
2. Company Constitutions; and
3. Ancillary investment documents, such as Side Letters.

Pre-emptive rights help existing shareholders retain control over the company by maintaining (or sometimes even increasing) their existing ownership proportion and preventing unwanted third parties from gaining an ownership stake.

How Do Pre-Emptive Rights Work?

The mechanics of pre-emptive rights depend on the specific terms set out in the relevant agreement. Generally, they apply in two key scenarios:

1. Issuance of New Shares
   When a company raises capital by issuing new shares, pre-emptive rights give existing shareholders the option to purchase a pro-rata proportion of these shares before they are offered to external investors.For example, if a company issues 1,000 new shares and an existing shareholder with pre-emptive rights owns 10% of the company’s shares, they may have the right to buy 100 of those shares to maintain their ownership percentage.
2. Transfer of Existing Shares
   If a shareholder wants to sell their shares, pre-emptive rights typically require them to first offer those shares to existing shareholders on the same terms before selling them to an external party.For example, if a shareholder agrees to sell their shares for $50 per share to a third party, they must first offer them to existing shareholders with pre-emptive rights at the same price and on the same terms. The existing shareholders with those rights can then elect to purchase their pro-rata proportion of the shares proposed to be sold. Generally, only if the existing shareholders decline the offer, or waive their pre-emptive rights, can the shares be sold to an outsider.

Oversubscription Rights and ‘Major Shareholders’

Not all shareholders may have pre-emptive rights to begin with. Sometimes, companies restrict these rights to ‘major shareholders’ who hold a certain proportion of the company’s share capital. For example, a company’s Shareholders’ Agreement may only grant pre-emptive rights to shareholders holding more than 5% of the company’s issued shares. Companies and investors may wish to restrict pre-emptive rights to major shareholders to streamline capital-raising and share transfer processes, reduce administrative complexity, and ensure that key investors maintain their influence and proportional ownership without excessive fragmentation.

It is important to note that some companies may offer shareholders (or certain major shareholders) ‘oversubscription rights’. An oversubscription term in pre-emptive rights clauses allows the holder of the right to subscribe for additional shares beyond their pro-rata entitlement in a new issuance or disposal scenario, typically when other shareholders choose not to take up their full allocation. Oversubscription rights help prevent dilution for active shareholders and can be particularly beneficial in closely held companies or capital-raising and exit scenarios where demand exceeds initial expectations. However, these rights are usually subject to limits set by the company or outlined in the company’s Shareholders’ Agreement to ensure fair allocation.

Why Are Pre-Emptive Rights Important?

1. Protection Against Unwanted Investors
   In private companies, existing shareholders may have a legitimate interest in controlling who becomes a shareholder. If a prospective investor is a competitor or notoriously conservative or difficult to deal with, the existing shareholders may prefer to invest capital to avoid the new investor jeopardising the company’s prospects. Pre-emptive rights ensure that shares are first offered to insiders before external parties can acquire them.
2. Preventing Dilution
   When a company issues new shares, pre-emptive rights allow shareholders to maintain their percentage of ownership, and in the case of oversubscription rights, may potentially enable them to increase their ownership stake.
3. Enhancing Shareholder Confidence
   By granting existing shareholders the first right to purchase shares, companies reinforce trust and confidence among investors, making it a more attractive environment for capital investment. Investors may be more willing to invest in a company if they know they will be looked after in the future. Early investors taking on significant risk may want the opportunity to increase their upside if the company is doing well.
4. Preserving Voting Power
   Shareholder influence in company decisions is often tied to shareholding percentages. By exercising pre-emptive rights, shareholders can protect their voting power and decision-making ability.

Can Pre-Emptive Rights Be Waived or Excluded?

Yes, pre-emptive rights can be:

1. Waived by existing shareholders in writing;
2. Excluded from the Shareholders’ Agreement and/or Constitution of the company entirety if the company and shareholders decide they are unnecessary; and
3. Overridden if the company’s governance documents contain exceptions in which pre-emptive rights will not apply (for example, share transfers to affiliates and securities issued under an employee incentive scheme or with certain board or shareholder approvals).

Key Considerations for Companies and Investors

If you are a company director, a shareholder, or a prospective investor, here are some key factors to consider:

1. Review the company’s Constitution and Shareholders’ Agreement to confirm if pre-emptive rights apply. Do they apply to the issue and transfer of shares, or do they extend to all securities more broadly (such as options, warrants, SAFEs and convertible notes)? Are there oversubscription rights? Are the exceptions to the pre-emptive rights provisions, if any, reasonable?
2. Consider the impact on future funding rounds and exits – strict pre-emptive rights provisions may deter external investment and prevent the company from partnering with strategic investors, ultimately hindering growth.
3. Understand timing, process, and administrative requirements – pre-emptive rights typically have strict timelines and processes. Are offers required to be left open for an unreasonably lengthy time? If so, this could delay a capital-raising transaction or disposal event.
4. Seek legal advice if issuing or transferring shares to ensure compliance with pre-emptive rights obligations.

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Pre-emptive rights are a valuable tool for shareholders who want to protect their ownership, prevent dilution, and control the introduction of new investors. However, these rights can also limit a company’s flexibility when raising capital or transferring shares.

Understanding how pre-emptive rights work and when they apply is essential for any shareholder or investor in a private company. If you need guidance on structuring pre-emptive rights in your Shareholders’ Agreement or investment transaction, contact our experienced corporate lawyers at 03 9481 2000 or info@tauruslawyers.com.au.