Knowledge Base: Pre-emption rights: what founders & investors need to know

This guide covers the statutory pre-emption right (also known as a right of first refusal) that applies on the allotment and issue of new shares under section 561 of the Companies Act 2006.

Jump to needed section here:

• What are pre-emption rights?
• When do pre-emption rights come into effect?
• Pre-emption rights in a new share issue
• Why is this important for investors?
• Exceptions to statutory pre-emption rights
• Waiving pre-emption rights on FounderCatalyst

What are pre-emption rights?

Pre-emption rights give existing shareholders the first right of refusal when a company issues new shares. This means they get the opportunity to maintain their percentage ownership by purchasing a proportionate number of the newly issued shares before they are offered to external investors.

Essentially, pre-emption rights protect existing shareholders from dilution while ensuring that new investors cannot buy in without first giving current shareholders the chance to invest. The principle is that shareholders should be able to protect their shareholding from dilution on the same or more favourable terms, pro rata to their existing shareholding.

When do pre-emption rights come into effect?

Pre-emption rights typically come into effect when a company raises money through a new funding round - pre-emption rights allow existing investors to buy shares before external investors.

In practice, if you want a person or persons to take all of a new issue of shares (e.g. an investor might not invest unless they get the required %, and won’t engage in a process at all unless they know pre-emption rights will be waived), then a pre-emption waiver for the whole share issue would be needed and a 75% special resolution passed. This is almost always the case - pre-emption rights are waived entirely, based on a cap table agreed between the company, the existing investors and the new investor.

Pre-emption rights are outlined in FounderCatalyst’s Articles of Association.

Pre-emption rights in a new share issue

When a company issues new shares, it must notify shareholders and offer them the opportunity to purchase shares proportionate to their current ownership. The process generally follows these steps:

1. Company announces a new share issue and informs existing shareholders - the pre-emptive offer may be made in hard copy or electronic form. The terms of the pre-emptive offer must be the same or more favourable than the subscription terms to be offered to third parties. When calculating pre-emptive rights, only issued shares are considered. Unissued shares, such as those reserved in the option pool, are excluded because they don’t yet exist.

2. Existing shareholders have a set period to decide whether they want to buy additional shares - the pre-emptive offer must specify an acceptance period which cannot be less than 14 days from the date on which the offer is sent.

3. If shareholders take up their rights, they purchase new shares in proportion to their existing ownership (as nearly as practicable)

4. Any remaining shares that are not purchased can then be sold to external investors - the company will be unable to allot any shares that are subject to the pre-emption regime until the specified acceptance period has expired, or (if earlier) an acceptance or refusal of the offer has been received from every recipient.

In practice, the great majority of follow-on equity funding rounds by start-ups do not follow a right of first refusal, or “pre-emption” process. However, it is almost always the case, and as per the FounderCatalyst documentation, that existing shareholders do have this right enshrined in their articles of association/shareholders’ agreement, and/or under UK company law.

Let’s take an example and work through what would typically happen. You’re planning to raise £150,000.

1. First, you should inform your existing shareholders about your intention to raise the funds, explain why the capital is needed, and outline how it will be used. Ideally, they’ll choose to reinvest but you should also let them know that pre-emption rights will be waived at closing, allowing you to raise more external capital.

2. If any of your existing shareholders decide not to waive their pre-emption rights, that means they wish to participate in the round - which is great news. In that case, determine how much they’d like to invest and include them as participants in the funding round on the FounderCatalyst platform. The process then continues exactly as it did for your previous round.

3. Once you’ve accounted for your existing shareholders, you can then seek new investors to complete the raise and add them to the round.

4. At closing, all existing shareholders (including founders) sign a special resolution confirming that they have waived their pre-emption rights over the new shares.

If some of your existing shareholders wish to invest in the same proportion as before, you’ll need to wait until the final amount raised from new investors is confirmed. For example, if the total raised is not exactly £150,000 (whether higher or lower), those existing shareholders will need to adjust their investment amount (i.e., the number of shares they purchase), since the total number of shares after the round will change accordingly.

Why is this important for investors?

Let’s take a scenario - if a company raises £1 million at a £20 share price, the new investors might collectively own 27% of the company. If the founder later attempted to issue new shares to friends at £0.10 per share, this would cause substantial dilution to the existing investors. However, since those investors hold 27%, they could use their voting power to block such a move, as a vote by the holders of at least 75% of the issued voting shares is required to waive pre-emption rights.

It’s worth noting that, in early-stage funding rounds, investor shareholders may not yet hold that level of ownership after the first round (typically dilution is 15-20% in a funding round) or may not have a fully established relationship of trust with the founder. In these cases, investor consent provisions are critical to ensure investors can prevent unfair or dilutive share issuances. In the FounderCatalyst paperwork Investor Majority Consent you will see the following consent matter:

“Create, allot, issue, buy in or redeem any share or loan capital, or grant (or agree to grant) any options or warrants for the issue of any share or loan capital, or issue any securities convertible into shares, or establish any employee incentive scheme, except in accordance with the New Articles or this agreement.”

See more on FounderCatalyst Investor Consents

Exceptions to statutory pre-emption rights

While pre-emption rights are designed to protect existing shareholders from dilution, there are certain situations where these rights do not apply. These exceptions include:

• Non-cash consideration - If shares are being issued in exchange for goods, services, or other non-cash assets, pre-emption rights do not apply.

• Employee share schemes - When shares are allocated as part of an employee incentive scheme, existing shareholders typically do not have the right to purchase these shares first.

• Company restructuring or financial distress - If a company is facing financial difficulties and issues shares as part of a compromise or arrangement with creditors or members, pre-emption rights may be set aside to facilitate the company’s recovery.

• Treasury shares - If a company holds its own shares in treasury and later reissues them, these shares are not considered part of the company’s ordinary share capital, meaning statutory pre-emption rights do not apply.

Waiving pre-emption rights on FounderCatalyst

On the FounderCatalyst platform you will need consent from the majority (75% or more in terms of voting shares held) of your existing shareholders. The 75% includes voting Founder shares. This will be signed on closing the round.

See our Special Resolution below: