Share issues, dilution and pre-emption rights in a shareholders' agreement

Introduction

This article explains how granting a right of first offer (RFO) to shareholders within a shareholders agreement can prevent share dilution.

What is dilution?

Dilution means a reduction, either in value (economic dilution) or relative ownership (percentage dilution). Both can occur together, or one can occur and not the other.

Dilution happens when a company issues new stock or an investor converts convertible instruments (for example, convertible debt or convertible preference shares) to ordinary shares.

Percentage dilution reduces the relative power that a shareholder has in setting the direction or the company and controlling the operation. If a company issues new shares and one shareholder doesn't buy more shares from the new issue, then the number of shares he owns as a percentage of the total number issued decreases. Of course, in order not to suffer percentage dilution, he needs to buy at least the percentage of the new issue that equals his old ownership percentage. For example, a member who owns 30% of the company before an issue must buy at least 30% of the new shares to remain a 30% owner after the issue.

Economic dilution reduces the value of a shareholder's investment. Economic dilution occurs when shares are issued at prices that change the average value per share. For example, if a company issues 100 x £1 shares, then total share capital is £100 and the average value per share is £1. If it then issues another 50 shares at £0.25, then total share capital is £112.50 and the average value per share is £0.90. Shareholders who bought shares in the first issue suffer economic dilution as the average value of each of their shares falls by £0.10.

Why should shareholders be concerned?

The decision to issue share capital is not one that by default requires unanimous agreement by all shareholders. Sometimes, the decision can even be made by the directors alone.

A large shareholder may find that although he is able to sway shareholder decisions, he may not have the same relative power in board decisions and may not be able to prevent the board from issuing new capital and reducing his voting power on shareholder decisions. The investment rationale of a large investor's stake is likely to depend on his relatively stronger position to control decisions. He may find that a decision by the board dilutes his ability to control other issues that require shareholder approval and that have greater impact on the value of his investment.

A minority shareholder may find that the board or a majority shareholder approves the issue of shares without it being in his interest. The effect could be to reduce his decision making capabilities further, or reduce the value of his investment. Founders with small shareholdings may find themselves edged further out of making decisions about how the company is run.

Right of first offer

Right of first offer gives existing shareholders the right to buy shares in any new issue before the shares are offered to external parties. In other words, this is the right to buy new shares before outsiders can.

Usually, a limit is put on the number of shares any shareholder can buy - to the proportion that he already holds - so that he can prevent dilution, but can't strengthen his position as a result of being an insider.

It is possible that the company could sweeten the deal for existing shareholders by allowing them to buy at a discount or reduced price.

What if a shareholder can't afford to buy more shares?

If a shareholder can't raise the money to buy the shares, then he can't participate. These are the rights to be able to act to prevent dilution, not the rights to never suffer from dilution.

However, having either of these rights confers another benefit, and that is that a shareholder must be told before an issue or sale takes place. Depending on the circumstances, he may be able to stop it or act in such a way as to minimise his disadvantage from it occurring. Without the right, events may be able to occur without shareholders being aware that their control or investment value is about to diminish

Further information and documents

This is one article about the terms that you should include within your shareholders agreement. Other similar articles include:

Controlling the entry of new shareholders: right of first refusal within a shareholders' agreement

Drag along clauses within shareholders' agreements

Tag along clauses within shareholders' agreements

If you are looking for an agreement, you may be interested in the following version, which includes these clauses: Shareholders agreement: company with shareholder directors and institutional investors.

Or you could choose from our collection of other shareholders agreements.