What are pre-emption rights? Should you care about them?

September 11, 2019

what are pre-emption rights

Pre-emption rights are often referred during negotiations for funding rounds as being key for founders and other existing shareholders. Similarly, investors talk about them as one of the most important terms for share investments.

What does pre-emption mean?

Pre-emption rights enable existing shareholders of a company to buy the company’s shares before they are offered to any third party on either an issue of new shares, or a share transfer by an existing shareholder.

The shareholder’s pre-emption rights are usually proportional to that shareholder’s existing holding, so that, for example, if the shareholder holds 20% of the shares, that shareholder will be entitled to 20% of the shares being issued or transferred.

What happens without pre-emption rights?

Without pre-emption rights, on either an issue of shares or a share transfer, a shareholder has no control over:

  • relative percentage holdings between existing shareholders being changed – one shareholder, for example, may gain a controlling stake either alone with others
  • new investors being brought into the company.

In the case of an issue of new shares, a shareholder has no control over its percentage holding in the company being reduced (this is known as ‘dilution’)

Is dilution bad?

A shareholder being diluted is not necessarily bad. The same will occur in any event if an existing shareholder decides not to buy further shares in follow-on funding rounds. The company seeking to grow by seeking further funding rounds is (generally) positive. It could lead to the company growing in value, so that the smaller percentage of the pie is worth more than before.

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Should you care?

In many new funding rounds, pre-emption rights will be disapplied by a special resolution (75% majority) of the shareholders.

If pre-emption rights apply, new investors will be keen to see whether existing investors take up their pre-emption rights, and at the same time, note that will reduce the number of available shares. This could be important if the new investors have a target ownership percentage.

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Do investors automatically have pre-emption rights?

Most companies will have disapplied the statutory pre-emption rights under the Companies Act in favour of bespoke pre-emption provisions in the company’s articles of association.

The pre-emption rights set out in the articles of association can, however, be disapplied by a special resolution (75% majority) of the shareholders. Investors accordingly usually include pre-emption rights in the investment agreement with the company so as to ensure that pre-emption rights remain even if the articles of association are changed.