Keeping control, or what are pre-emption rights and why do they matter?

One of the things many entrepreneurs overlook in the rush to form a company and start their new business venture is the importance of giving thought to which individuals have ultimate control over the company.

One of the advantages of going into business with someone else is that each person brings something to the table that the others don’t have. Some people have technical skills, some are skilled in business and finance, and others in marketing. Different skill sets will have prominence at different stages of the business and, as these change over time, it can lead to friction between the owners and managers of the business. A particularly common source of friction is between those who provided the initial finance to set up the business, and those who have the marketing and management skills to take it further who see the initial funder as a burden to growth.

Who controls a company?

It is important to remember that directors and shareholders have different roles. Shareholders own the business but it is the directors who manage and control it. The shareholders’ powers over running the business are limited: they can remove a director and, in certain circumstances, can direct the board to take or refrain from taking certain decisions. Whilst it is common to add a clause to the company’s articles or shareholders’ agreement stating that certain decisions can only be made by the shareholders, or a certain proportion of them, this is not the default position.

Companies often start with the directors and shareholders being the same people. However, for various reasons, a director may leave, maybe to do something else, or because of disagreements with other board members, or simply to retire. Unless there are clauses in the Articles or Shareholders’ Agreement stating that shareholders must offer their shares for sale if they no longer remain as a director, they will continue to hold shares in the company. This means that they must be paid their share of dividend payments, and have some say over who the directors are and certain decisions of the company.

If no thought is given to these matters then the default position is that any shareholder can sell their shares to anyone else, and can’t be forced to transfer their shares if they stop being a director. In reality, they have the ultimate control over their shares and, to put in bluntly and depending on the amount of their shareholding, can be a thorn in the side of the other shareholder-directors.

The way to avoid these sorts of problems is to have the Articles amended and/or a Shareholders’ Agreement drafted. Usually, both will need to be done to ensure that they correspond with each other.

Pre-Emption Rights

The clauses that should be added deal with what is known as ‘pre-emption rights’. Each company will be different but they usually provide that, if a shareholder wants to sell his shares, he must first offer them to the other shareholders. They don’t have to buy them but usually have a right of first refusal. If the other shareholders do not wish to buy the shares or cannot afford to do so, then the shareholder who wishes to sell his shares the usually has the right to sell them to anyone else he wishes. Sometimes, a right is given to the directors to refuse to register a share transfer to anyone they don’t approve of.

If a price cannot be agreed, then a mechanism is set out. It will commonly provide for the shares to be valued by either the company’s accountant or an independent valuer. Sometimes, directions as to how the shares are to be valued will be set out. There will often be a provision that the value of someone’s shareholding corresponds to the percentage of the shares they own, e.g. a 25% shareholding is worth 25% of the value of the company (as otherwise it will be worth less than this).

Sometimes, the Articles and/or Shareholders’ Agreements state that, if a director ceases to be a director, then a transfer of his shares is triggered automatically so that the other shareholders have the right to purchase his shares if they choose to do so. Occasionally, there are clauses to change the class of shares held by the leaving director to those which don’t have voting rights (although are still entitled to dividends).

Other things to consider include what will happen if a shareholder dies. The default position is that his shares will automatically be transferred to his next of kin. This is not usually what a small company would want to happen.

Get Advice Before Problems Arise

Each company will come to different conclusions as to what clauses should be in its Articles and Shareholders’ Agreements to control the company’s shareholding. The important thing is to talk through these points with a solicitor and before any issues arise between the shareholders. The worst time to realise that you can’t do what you want and could lose control of your company is after a dispute has arisen.

We are happy to talk through your options with you and to advise on what clauses would be best for your company. We can then draft a Shareholders’ Agreement and amended Articles. We can also advise you on your rights if a dispute does arise.

Gary Cousins
Business Solicitor

For free advice on this topic please call us on 0845 003 5639.