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Pre-emptive rights are very common in startups. Such rights will affect your company’s shareholders if your company is issuing new shares or if your shareholders are transferring shares. Notably, shareholders’ pre-emptive rights affect the process by which your company can issue shares, or its shareholders can sell shares. Indeed, it is important to understand what they are and how they can impact your startup. This article will explore:

  • what pre-emptive rights are;
  • when shareholders will have these rights; and
  • what they mean for your startup and shareholders in the context of private (pty ltd) companies.

What Are Pre-emptive Rights?

Pre-emptive rights allow shareholders to subscribe for new shares or purchase existing shares before any third parties. Unallocated shares are generally either re-offered to existing shareholders or offered to a third party. When your shareholders have pre-emptive rights, they can subscribe for new shares that your company issues before your company issues those shares to third parties. They can also purchase shares that another shareholder sells before the shareholder offers them to third parties. If all shareholders elect to take up their pre-emptive rights, they are allocated the number of shares that reflects their ownership proportion of the company. This proportion excludes the selling shareholders’ ownership proportion. This is because a selling shareholder will not have pre-emptive rights over the shares it is selling.

For example, a shareholder currently holds 10% of the company and the company wants to issue an additional 20,000 shares at a price per share of $5.00. Assuming all the other shareholders take up their pre-emptive rights, that shareholder would have the right to invest in an additional 10% of those 20,000 shares (or $10,000 for 2,000).

Similarly, if a shareholder is selling 100 shares in the company, an existing shareholder with a 10% ownership stake (excluding the seller’s ownership stake) can purchase 10 of the seller’s shares. However, the shareholder has no obligation to buy or subscribe to the entire 10%.

Why Do Companies Give Shareholders Pre-emptive Rights?

There are several reasons why companies give shareholders pre-emptive rights. Pre-emptive rights enable shareholders to avoid dilution of their investment when the company issues new shares. In other words, this prevents their ownership percentage in the company from decreasing. This is because any time that your startup raises capital, it will need to issue additional shares. As you are issuing additional shares, your existing shareholders could end up with a smaller ownership percentage of the company. However, if a shareholder wants to avoid dilution, they can invest additional capital for additional shares by using their pre-emptive rights. This allows them to maintain the same ownership percentage of the company.

For example, a shareholder holds 10% of the company. When your company issues new shares, a shareholder with pre-emptive rights can acquire 10% of those new shares. Doing so allows them to maintain their 10% ownership stake in the company.

Pre-emptive rights on a transfer of shares protects existing shareholders by allowing them to take up any shares before third parties. This allows them to increase their ownership interest while also preventing unknown external parties from becoming shareholders in the company. Because pre-emptive rights are proportionate to a shareholder’s ownership stake, all shareholders have an equal right to purchase a selling shareholder’s shares. This way, a shareholder with pre-emptive rights cannot buy all the shares and unfairly increase their shareholding in the company.

How Do You Know if Your Shareholders Have Pre-emptive Rights?

Shareholders’ pre-emptive rights are very common. As a result, your shareholders likely have these rights. To confirm whether pre-emptive rights exist in your company, you should first check your company’s shareholders agreement. If your shareholders have them, you will generally find pre-emptive rights in the clauses relating to share issues and share transfers. Usually, the clauses will refer to the company’s or selling shareholder’s requirement to offer shares to existing shareholders first.

If your company does not have a shareholders agreement, check your company constitution to confirm whether it contains these rights. If your company also does not have a constitution, the replaceable rules in corporations law apply. These rules state that existing shareholders have pre-emptive rights on the issue of new shares. Unless your company’s shareholders agreement or constitution explicitly overrides this replaceable rule, your shareholders will have pre-emptive rights.

What Is the Pre-emptive Rights Process?

If your company’s shareholders have pre-emptive rights, there will generally be a prescribed process that you and your shareholders must follow when issuing or selling shares. Firstly, your company’s directors or selling shareholders must prepare a notice setting out the terms of the issue or the sale. The notice will need to include details of the number of shares on offer and the price per share. This notice is circulated to all existing shareholders (other than the seller, in the case of a share transfer).

The existing shareholders (other than the seller in a share transfer) will have a timeframe during which they can take up the offer contained in the notice. Each shareholder wishing to subscribe for, or purchase shares, will need to tell the board in writing how many shares they wish to subscribe for or purchase. If the total number of shares taken up is greater than the total number of shares on offer, each shareholder will be allocated shares at their respective proportion. This could be less than the amount they wish to subscribe for or purchase. If the total number of shares taken up is less than the total on offer, any remaining shares are either re-offered to the shareholders or offered to a third party.

Key Takeaways

Pre-emptive rights are commonly given to a company’s shareholders. These rights enable shareholders to subscribe for or purchase shares in the company before they are offered to third parties. This means a shareholder can maintain or increase their ownership stake in the company. They can also prevent unknown third parties from becoming shareholders. You should check your company’s constitution and shareholders agreement to determine whether shareholders have pre-emptive rights. If so, your company directors and shareholders need to follow a certain process when issuing or transferring shares. If you have questions about shareholders pre-emptive rights, get in touch with LegalVision’s startup lawyers on 1300 544 755 or fill out the form on this page.

Frequently Asked Questions

What are pre-emptive rights?

Pre-emptive rights allow shareholders to subscribe for new shares or purchase existing shares before any third parties. These rights also allow shareholders to purchase shares that another shareholder sells before the shareholder offers them to third parties.

Should my company give out pre-emptive rights?

Pre-emptive rights enable shareholders to avoid dilution of their investment when the company issues new shares. Ultimatelty, this prevents their ownership percentage in the company from decreasing.

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