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In our previous article on ‘5 key concepts on transferring shares under a SHA’, we looked at those key clauses common across 3 sets of model shareholder arrangement documents published by 3 venture capital (VC) associations.

These common concepts provide guidance as to what you might minimally want in your shareholders’ agreement on transferring shares.

To recap, these are the template shareholders’ agreements which we took a closer look at:

1. the US based National Venture Capital Association,
2. the British Private Equity & Venture Capital Association, and
3. the Australian Private Equity & Venture Capital Association.

In this article, we take a closer look at 5 key differences between the 3 sets of VC model documents on pre-emptive rights.

Recap on pre-emptives

Pre-emptive rights[1] were dealt with in Concept 3 in our previous article. They are a subset of the types of provisions you might find in a shareholders’ agreement dealing with transferring shares.

Firstly, you won’t need a pre-emptive right unless there is a general restriction on transfers of shares. You might want such restrictions to ensure that key team members’ economic interests remain fully aligned with the success of the business or so that there is stability in your share register.

If you do have general restrictions, pre-emptive right provisions help you balance a wish by all shareholders to realise their investment against factors counselling in favour of the restriction.

Difference 1 – Who grants the pre-emptive right or who must not sell their shares without undergoing the pre-emptive right procedure?

All 3 sets of model documents have different positions on who grants the pre-emptive right – it ranges from only the founders, an identified list of key holders or all shareholders.

Investors might insist on the founders and key holders granting a pre-emptive right as a compromise to their preferred position that founders and key holders should be restricted from simply abandoning the business after investors have poured money into it.

On the other hand, subjecting all shareholders to pre-emptive restrictions might sound fairer.

However, investors might argue that they are in the business of buying and selling shares over a defined time horizon and shouldn’t be restricted from doing so. Further, an investor’s contribution of money to the business occurs at the start of their involvement with the business and there is less need to bind them to the business over the longer term.

Minor shareholders might argue that their replacement on the register is unlikely to have a significant effect on the business or other shareholders – selling a small parcel of shares should not be restricted. Having said that, keep in mind that even minor shareholders have certain rights which cannot be contracted out of (such as the right to sue for oppression) and you may want to be careful as to who your minor shareholders are.

The simple question of who should be granting the pre-emptive right requires deeper analysis and it is interesting to note that all three templates present differing positions.

Difference 2 – Who is the beneficiary of, or who may buy shares under, the pre-emptive right?

Another key difference is who may opt to buy shares if the pre-emptive right is triggered. Should the pre-emptive right be exercisable by investors, founders, key holders, all shareholders or the company (or a combination of them)?

In answering that question, you may want to consider at least the following:

1. Each shareholder will want an option to buy shares under the pre-emptive since it rarely comes with an obligation to buy.
2. Each shareholder has an incentive to keep the list of beneficiaries of the pre-emptive small – the smaller the group, the more shares there are to buy for those in the group.
3. Granting a right to too large a group may make the pre-emptive process unwieldy and uncertain. Too narrow a group may seem unfair.
4. A shareholder who is unlikely to raise funds in time to purchase shares on offer under the pre-emptive provisions may want the company to have a first right to ‘mop-up’ the shares.

Each of the 3 sets of VC model documents strikes a different balance:

1. One requires that the company has the first right to purchase shares under the pre-emptive provisions. If the company does not purchase all shares on offer, investors have a secondary right to purchase the remaining shares.
2. Another gives investors the sole right to purchase shares under the pre-emptive provisions.
3. The last gives all shareholders an equal right to purchase shares.

Finally, this is an area where differences in corporate law will matter. In some jurisdictions, a company must not agree to a share buy-back unless it has received shareholder approval. You will want to look carefully at how rights are drafted.

Difference 3 – When must an offer be made under the pre-emptive right?

When is the pre-emptive process initiated or when is an offer of shares to be made?

Once again, all 3 sets of model documents take a different position:

1. One specifies that an offer must be made to sell shares under the pre-emptive right by a date prior to the proposed date of transfer to a third party.
2. Another has the pre-emptive provisions triggered where a shareholder has a ‘wish’ to sell its shares.
3. The last set of VC model documents forgets to expand on what the term sheet means by having a ‘right of first refusal’.

This is an important point for potential ‘givers’ as well as ‘takers’ under pre-emptive provisions, not to mention consequences for enforcing the provision.

The range of options is not fully reflected in these model documents and there are at least two considerations:

1. Must a seller ‘test the market’ with fellow shareholders before looking for a third-party purchaser?If so, that might alert fellow shareholders to the wish to sell early on and set off a reaction to that. That might also mean that the seller does not have a clear third-party tested price when it is required to initiate a pre-emptive offer.
2. Must a seller have a third-party binding offer in hand before triggering the pre-emptive process?If so, that might mean greater uncertainty for a seller and their potential purchaser with potential consequences for the third-party transfer price and terms.

Difference 4 – How long do you have to decide on whether to take up the offer?

Another critical timing window is that for pre-emptive right holders to decide on whether to buy shares under the offer.

Based on 2 sets of the VC model documents, right holders generally have about 10 business days to 15 days to decide.

If a right holder can’t determine during the offer period if the price offered is a good one or whether they will be able to fund a purchase, the pre-emptive right may be illusory.

If the period is too long, sales of shares to a third party may be overly restricted. Where there is a primary and secondary pre-emptive process, timing becomes even more important with two offer periods instead of just one.

Difference 5 – How prescriptive or flexible is the pre-emptive provision?

If you haven’t already picked this up, we think details matter. What you include in your drafting can give you flexibility and what you exclude can make your pre-emptive process too narrow and prescriptive.

Two examples of this from the 3 sets of VC model documents:

1. The information required to be included in the offer notice may be the difference between a ROFR or a ROLR.

An offer notice from the seller should include material terms such as the number and class of shares to be sold, price, terms and intended date of the transfer. Whether an offer notice is to include the identity of the prospective transferee should largely follow from whether a third-party offer must first be obtained before the pre-emptive is triggered. Sometimes a requirement for such notice may result in an interpretation of the provision as a ROLR.

2. What happens if a third party offers non-cash consideration, such as scrip in another company.

Right holders are usually expected to exercise their rights on the same terms as the proposed transfer. Of the 3 sets of VC model documents, only 1 provides for a situation where the consideration proposed is non-cash consideration such as scrip, property or services. In this situation, one option is to provide that the cash value equivalent should be offered under the pre-emptive instead. Without such an elaboration, offering the same form of non-cash consideration may disadvantage potential sellers and buyers.

Conclusion

Shareholder agreement templates, even from VC associations, can vary. Some of these nuances may have a significant impact if they don’t reflect your intentions. Shorthand drafting is unlikely to deal with important points and potentially affect the provision’s workability and enforceability.

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[1] Sometimes called a right of first refusal (ROFR), right of last refusal (ROLR), rights of first offer (ROFO), right of last offer (ROLO). Each of these are different in concept.

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Read more on our analysis of model shareholder arrangements published by venture capital associations including on:

• Similarities in board and shareholder control provisions – 3 key control concepts for a SHA
• Similarities in transfer of shares provisions – 5 key concepts on transferring shares under a SHA
• Different options for board control provisions – 5 key options for board provisions in a SHA
• Different options for drag-along provisions – 5 key areas in drag-along provisions in a SHA
• different options for reserved matters – 5 key considerations for a reserved matters list in a shareholders’ agreement

You may also be interested in our thoughts on:

• Singapore model documents – VC model documents for Singapore
• choosing a template agreement – 6 tips for picking a template agreement

Read more about our lawyers’ fundraising and joint ventures experience.

Get in touch to explore how we may help you with your shareholder arrangements.

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This article is provided for general information purposes only and does not constitute legal or other professional advice. Legal services are only provided to clients under an engagement letter. Other communications do not give rise to a solicitor-client relationship or constitute the provision of legal services.