‘Pre-emption’ clauses are used in many Shareholder Agreements and Constitutions, and for very good reason, as we explain below. However, not all pre-emption clauses are equal. In fact, a well drafted agreement should include at least two completely different varieties – and there are a lot of potential traps in both types.
Pre-emption on transfer
The first type of pre-emption clause applies when someone wants to transfer an existing interest in an enterprise.
A ‘pre-emption on transfer’ clause requires the person wanting to transfer the interest in the enterprise to first offer the interest to the other owners before looking to transfer the interest to a third party.
The other owners of the business then have the right (but not usually the obligation) to acquire the interest being offered for sale, usually in proportion to their existing ownership interests.
If the other owners do not take up this right to buy, the exiting owner is then able to sell the interest to a third party. However, the exiting owner must not deal with the third party on any more favourable terms than applied under the offer to the other owners.
Pre-emption on transfer rights provide the continuing owners with a number of important protections:
- The first is to protect the continuing owners against an exiting owner selling directly to a third party, bypassing the other owners – and potentially involving a third party whose interests may conflict with those of the other owners or the enterprise (e.g. a competitor); and
- The other, and perhaps more important protection, is the ability of the continuing owners to preserve their relative ownership interests in the business, i.e. to stop one owner selling to another owner, and giving the second owner a much higher (and potentially controlling) interest in the business.
There are number of important things you need to consider when agreeing to a pre-emption on transfer arrangement:
On what terms can the other owners purchase the interest being offered?
Commonly, the exiting owner nominates the terms, including price, on which they are prepared to sell. However, in some instances, the other owners (or the enterprise’s board) have the right to get the equity independently valued. If this is the case, then the exiting owner will want the right to withdraw from the process if the value is below what they are prepared to sell for. However, in many instances this last piece is missing, i.e. the exiting owner must commit themselves to selling at a price that they do not yet know.
Does the exiting owner need to identify a proposed third party purchaser?
Many older pre-emption clauses require the exiting owner to nominate a proposed purchaser for their interest at the time of giving the offer notice. In our view this can drag out the pre-emption process, because in many instances the most likely buyer is one or more of the other owners, i.e. a third party has not yet been identified – and may never be identified. Our view is that nomination of a proposed purchaser should not be a requirement.
Should the enterprise itself have the right to buy?
In many of our agreements we give the enterprise itself a first right to ‘buy-back’ the interest being offered by the exiting owner. The outcome of the buy-back is that the ownership interests of the other owners are increased in proportion to their existing ownership in the enterprise. It is often the case that the enterprise is in the best position to purchase, as it has all the relevant information and is able to provide security over its assets as a whole (which is generally not available to individual owners).
What if nobody wants to buy?
Quite often a business owner will want to sell for some reason, but none of the other owners (nor any third party) has the inclination or ability to purchase their interest. This is when a pre-emption clause can morph into a ‘buy-sell’ or ‘exit’ clause. When there is a small number of owners we often suggest that if the other owners are not willing to buy, and no third party purchaser can be found, then the whole business must be put on the open market. This usually results in the fairest outcome for the intending seller. In instances where there is a large number of owners, and the ownership interests are relatively small, it may be appropriate to give an exiting owner the ‘right’ to require the other owners to buy them out – so they are not stuck in the business indefinitely. In this scenario, the burden of raising the purchase price is shared by the other owners in proportion to their respective (relatively small) ownership interests.
What about funding the purchase?
Another way to facilitate a transaction between owners is to agree upfront to terms on which the exiting owner must provide ‘vendor finance’ to the other owners. For example, the purchase price may be spread over a number of instalments, with a rate of interest applying to the outstanding balance. You need to consider if the other owners will need to provide guarantees or security for the amount outstanding.
What information can a proposed seller give third parties?
Many Shareholder Agreements and Constitutions impose a confidentiality obligation on the owners, which makes it very difficult (if not impossible) for an exiting owner to attract a third party purchaser. It may also be the case that another minority owner does not have access to enough detailed financial information to assess whether or not to take up a pre-emption right. A potential purchaser will not be able to consider a purchase without detailed financial and operating information on the enterprise. One way to deal with this obstacle is to provide a limited right/obligation to disclose information in the context of a pre-emption process, with the potential purchasers having to agree to normal non-disclosure obligations before getting the information.
Are there any exceptions?
It is common to exclude certain ‘permitted transfers‘ from the pre-emption provisions. This means that an owner can transfer their equity in the enterprise to a ‘permitted transferee’ without having to first offer the equity to the other owners.
Common permitted transferees include family members, wholly owned companies, and any trusts and super funds controlled by the owner. This allows common ownership ‘restructures’ to take place without triggering the pre-emption rights.
Pre-emption on issue
The other sort of pre-emption clause that your agreement should include relates to any new equity that is to be issued in the enterprise, i.e. a ‘pre-emption on issue clause’.
These provisions require the enterprise to first offer any new equity to the existing owners of the enterprise, and in proportion to their existing ownership interests.
This sort of clause avoids a controlling majority from being able to increase their proportionate interest in the enterprise. If someone does not wish to take up this pre-emption right, then the other owners are usually entitled to take up the additional equity.
Deemed pre-emption triggers
Pre-emption clauses are also very useful to give other terms of your Shareholders Agreement and Constitution ‘teeth’.
For example, if there is a change in control of an owner, the owner is then treated as having made a sale offer under the pre-emption on transfer provisions. Similarly, if an owner breaches a term of the agreement (for example, by competing with the enterprise, or not making an agreed contribution of some kind), then this can also trigger a deemed sale offer under the pre-emption on transfer provisions.
The effect of these deemed transfer offers is that the other owners then have the right to acquire the defaulting owner’s interest in the enterprise, and thereby ‘eject’ the defaulting party.
The pre-emption provisions within a Shareholders Agreement or Constitution also tie in with other transfer provisions, such as ‘tag-along’ and ‘drag-along’ rights.