Shareholders be aware: pre-emption rights and compulsory transfer provisions for private companies

What are pre-emption rights?

A pre-emption right is a right of first refusal for the other shareholders to acquire, usually on a pro-rata basis, shares from a shareholder who no longer wishes to hold shares. Pre-emption rights are either set out in the articles of association, the governing document which is filed at Companies House, or in a private shareholders’ agreement.

The fundamental purposes of pre-emption rights are to:

1. Preserve the status quo between the continuing shareholders following a share transfer by keeping the percentage shareholdings the same; and
2. Avoid disputes and disruption to the running of the company and its business should a shareholder decide to sell.

Pre-emption rights are not always in the forefront of shareholders’ minds when they are in agreement and share the same business values. However, this can change suddenly.

Without pre-emptions rights, a shareholder is free to transfer shares to any person. There is some protection however, as directors usually have discretion to refuse to register the proposed new shareholder in the register of members. This is important because a shareholder is only allowed to vote and receive dividends when registered in the register of members, but inevitably this will lead to disputes and does not give a clear position as the selling shareholder still holds the shares.

Conversely, there may be situations where it is not desirable for a shareholder to continue holding shares. Such circumstances could include: the shareholder leaves employment with the company, passes away or becomes bankrupt. Without express provisions requiring shares to be transferred, usually to the other shareholders on the basis of the pre-emption right procedure (compulsory transfer provisions), a shareholder cannot be forced to transfer their shares.

What issues might arise without having suitable compulsory transfer provisions and pre-emption rights?

1. Family members: On death of a shareholder, shares will inevitably transfer to a family member and the continuing shareholders could be stuck with the personal representatives or a new family member as shareholder, who may not necessarily agree with them or have any relevant experience. This can lead to protracted negotiations to seek to agree to buy the new shareholder out.
2. Relationship breakdown: It will not be easy to deal with an aggrieved shareholder in circumstances where the shareholders are spouses/partners, with one of the shareholders for tax reasons holding shares but not actively involved in the business, and the relationship breaks down but both individuals are able to keep their shares.
3. Third parties: If a shareholder wants out and wishes to sell to a third party, the shares could pass to a competitor or someone who has different business objectives.
4. Power dynamics: This may seem innocuous, but a transfer of shares between existing shareholders can lead to a shift in power.
5. Employee shareholders: You can be stuck with a shareholder who has been sacked or employed by a competitor. You can include “good leaver” and “bad leaver” provisions so an employee shareholder who leaves through no fault of their own, such as death, long term illness or retirement, is a “good leaver” and receives full value for their shares. An employee who is a “bad leaver”, for example, if they leave to work for a competitor, would not be rewarded with a payout and may receive nominal value for their shares.

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To avoid disputes, it is wise to include provisions confirming how the shares are valued and whether any discount should be applied to a minority shareholding or due to the reason for the compulsory transfer, such as good leaver/bad leaver.

If you would like advice on your shareholder arrangements and how to avoid disputes which could arise without the inclusion of pre-emption and associated compulsory transfer provisions, please contact Corporate Solicitor Bez Borang on 0161 838 7808 or Behzad.Borang@kuits.com.