The Importance of Pre-Emptive Rights in Private Companies

Introduction

Running a business with others can be complex and unpredictable. Life circumstances change unexpectedly, and in such moments, individuals often prioritize their personal interests. This reality is particularly evident in our world, which continues to grapple with the effects of a global pandemic and economic uncertainties.

One common issue that arises in business partnerships is the sudden need for a shareholder to exit the company. Unfortunately, many business owners fail to prepare for this eventuality, leading to disputes and complications. This is where pre-emptive rights, also known as “rights of first refusal,” become crucial.

Setting Up the Relationship Properly

A fundamental principle in business law is that relationships should be structured appropriately from the outset. While verbal agreements are legally binding in South Africa, they are difficult to enforce and often lead to costly disputes in court. The best way to avoid such complications is through comprehensive legal agreements.

A shareholders’ agreement is the most effective document for regulating the relationship between shareholders and the company. This agreement should explicitly address pre-emptive rights to ensure clarity and legal certainty.

Understanding Pre-Emptive Rights

Pre-emptive rights grant existing shareholders the first opportunity to acquire shares before they are offered to external parties. These rights serve as a protective measure for shareholders, ensuring that their ownership stake is not diluted and that control of the company remains within the existing shareholder group.

In relation to private companies, pre-emptive rights can take two main forms:

1. Pre-emptive rights on share transfers: A shareholder who wishes to sell their shares must first offer them to existing shareholders at the same or lower price as they would offer to third parties. This prevents unfair preferential treatment to external buyers.
2. Pre-emptive rights on new share issues: Section 39(2) of the Companies Act No. 71 of 2008 (“Companies Act”) grants shareholders the right to subscribe for a proportionate share of any newly issued shares before they are offered to outsiders. This right is automatic unless restricted by the company’s Memorandum of Incorporation (MOI).

Where Are Pre-Emptive Rights Addressed?

A shareholders’ agreement typically contains provisions for pre-emptive rights, though they may sometimes be embedded within clauses governing share transfers. In some cases, these rights may also be stipulated in the company’s MOI.

It is important to note that while section 39(2) of the Companies Act provides an automatic pre-emptive right for shareholders regarding new share issuances, a company’s MOI may modify or restrict this right. This means that shareholders must carefully review their company’s governing documents to understand their rights and obligations.

Risks of Omitting Pre-Emptive Rights

Failing to include pre-emptive rights in a shareholders’ agreement or MOI can pose significant risks, including:

• Loss of control: Without pre-emptive rights, a departing shareholder may transfer shares to an outsider, potentially bringing in an unwanted party.
• Dilution of ownership: If new shares are issued without giving existing shareholders the opportunity to subscribe, their ownership percentage may decrease.
• Disputes among shareholders: Ambiguities or the absence of pre-emptive rights can lead to costly legal conflicts.

How to Implement Pre-Emptive Rights

If pre-emptive rights are not already included in a shareholders’ agreement, the shareholders should take steps to rectify this by:

1. Amending the shareholders’ agreement – This can be done through an addendum or a revised agreement, subject to approval and signature by all shareholders.
2. Reviewing and amending the MOI – If necessary, modifications can be made to the MOI to ensure it aligns with the shareholders’ intentions regarding pre-emptive rights.
3. Consulting legal professionals – Given the complexity of corporate governance, legal expertise is essential in drafting and implementing these provisions effectively.

Conclusion

Pre-emptive rights are a crucial mechanism for protecting shareholders in private companies. While they may seem like a minor contractual detail, they can prevent significant complications when a shareholder exits or when new shares are issued.

The best time to establish pre-emptive rights is at the outset of a business relationship. If your company does not currently have these provisions in place, it is advisable to take proactive steps to incorporate them into your shareholders’ agreement and MOI. Ensuring clarity and legal protection today can safeguard your business from disputes and unintended consequences in the future.

For further assistance, consult an attorney at SchoemanLaw.