This article explains how granting a right of first offer (RFO) to shareholders within a shareholders' agreement can prevent share dilution.
Dilution means a reduction, either in value (known as economic dilution) or relative ownership (known as 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 of them from the new issue, then the number of shares they own as a percentage of the total number issued decreases. Of course, in order not to suffer percentage dilution, they need to buy at least the percentage of the new issue that equals their 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. It 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 £0.75. Shareholders who bought shares in the first issue suffer economic dilution as the average value of each of their shares falls by £0.25.
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 they are able to sway shareholder decisions, they 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 their voting power on those other matters.
The investment rationale of a large investor's stake is likely to depend on their relatively stronger position to control decisions. They may find that a decision by the board dilutes their ability to control other issues that require shareholder approval and that have greater impact on the value of their investment.
A minority shareholder may find that the board or a majority shareholder approves the issue of shares without it being in their interest. The effect could be to reduce their decision making capabilities further, or reduce the value of their investment. Founders with small shareholdings may find themselves edged further out of making decisions about how the company is run.
Right of first offer gives existing shareholders the right to buy shares in any new issue before they 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 they already hold - so that they can prevent dilution, but can't strengthen their 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. If there is, it might be accompanied by an anti-embarrassment clause to prevent the shareholders from selling on those shares immediately.
If a shareholder can't raise the money to buy the shares, then they can't participate. These are the rights to be able to act to prevent dilution, not the rights to never suffer from it.
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, they may be able to stop it or act in such a way as to minimise their 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
We offer a range of shareholders' agreement templates, including one that includes all these clauses.