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 owners. For this reason, they are also often referred to as ‘first rights of refusal‘.

To maintain equity among the continuing owners, 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 prior to the other owner exiting, then they are entitled to acquire 30% of the exiting owner’s equity. This is called their ‘proportionate entitlement‘.

However, if one or more of the continuing owners does not want to take up some (or any) of their proportionate entitlement, then the other continuing owners 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 an ‘overriding first right‘ to take up all of the exiting owner’s equity – in priority to the other continuing owners. In this scenario, the majority owners will increase their proportionate share of the equity (by the equity of the exiting owner). This will not impact the proportionate share of the equity held by the other continuing owners – who’s proportionate interest will remain the same.

For example, assume there are 3 owners, one with 55%, one with 25% and one with 20%, and the 20% owner exits. If the holder of 55% has an overriding first right of refusal to take up all of the exiting owners 20%, their interest will go from 55% to 75%. The ownership interest of the other owner will simple remain at 25%. So the other owner is not disadvantaged, they merely do not have the opportunity to increase their proportionate interest.

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 owner. The minority owners will thereby increase their overall percentage interest in the enterprise, while the proportionate interest of the majority will stay the same. This is often done when the majority owner is looking to retire from the enterprise over the medium to longer term, and wants the minority owners to gradually increase their ownership stake.

In the case of an enterprise that is a company or unit trust, the enterprise itself may have a first right of refusal to buy-back or cancel the equity stake of someone who leaves the enterprise. If this occurs, then the relative ownership interests of the continuing owners is increased. Furthermore, the increase in ownership interests occurs ‘proportional’ to the ownership interests held prior to the exit.

For example, assume there are 5 owners each with 20%, and one owner exists. If the enterprise buys-back or cancels the 20%, the all of the other continuing owners’ interest automatically increases by 5%, so the remaining owners end up with 25% each, without there being any transfer of equity as between the existing owner and the continuing owners.

The option of having the enterprise buy-back or cancel the equity of the exiting owner is often preferable, because it simplifies the exit in a number of respects. First, there is no need for a drawn-out offer and acceptance exercise involving the continuing owners. Second, the enterprise can source funding to make the buy-back, rather than having each owner having to access funding individually. Finally, the tax impacts of the exit are shared equitably between the exiting owner and the continuing owners, in that any portion of the exit value that is attributable to retained earnings are shared with the exiting owner.

For assistance putting in fair and flexible first rights of refusal into your owners’ agreement, call us on 1300 654 590.

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