Q&A – How do pre-emption rights work?

Most Shareholder Agreements, Constitutions and Partnership Agreements provide ‘pre-emption’ rights. These are rights that require someone wanting to sell an interest in the enterprise, to first offer the interest to the other equity holders.

To be fair, the proportion of the equity that the continuing participants are allowed to each purchase matches their existing holding. For example, if they hold 30% of the enterprise, then they are entitled to acquire 30% of the exiting participant’s equity. This is called their ‘proportionate entitlement’.

However, if one or more of the continuing participants does not want to take up some (or any) of their proportionate entitlement, then the other continuing participants are entitled to take up their proportionate entitlement of what is left over.

It is possible to alter these rights in a number of ways.

One way is for one or more of the majority owners to have a ‘first right’ to take up all of the exiting participant’s equity – in priority to the other continuing participants. In this scenario, the majority owners will increase their proportionate share of the equity (by the equity of the exiting participant). This will not impact the proportionate share of the equity held by the other continuing participants – who’s proportionate interest will remain the same.

Another way is for the majority to agree not to take up their proportionate entitlement of the equity when someone exits. This then leaves that equity to be taken up by the other minority participants. The minority participants will thereby increase their overall percentage interest in the enterprise, while the proportionate interest of the majority will stay the same.

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