What is a right of first offer clause and why include it within a shareholder agreement?
Such a clause confers a right to existing shareholders to subscribe for a new issue of shares before outsiders can do so.
Simply put, it allows an existing shareholder to maintain the proportion of the company that he or she owns and thus the amount of control he or she can exert over decision making.
New share issues and percentage dilution
New shares are usually issued in order to bring in outside investment into a company. Existing owners may agree to increase the number of shares in the company, which are then sold by the company to new shareholders at a premium to the value of the business. The sale proceeds collected by the company are used for further investment.
Dilution of ownership can occurs at any new share issue. If a company has 100 shares and issues a further 20, then a shareholder who held 40% of the shares previously would find that he held only 33% of them after the issue. The new issue has the effect of reducing how much say he has in the running of the expanded company.
Right of first offer allows him to buy some of the new shares (usually up to the proportion he held before) in preference to anyone else so that he can maintain his relative power compared to other shareholders.
The dilution referred to above is known as “percentage dilution”.
Shareholders can also suffer from “economic dilution”. This happens when new shares are issued that have a lower face value than old shares in the same class. For example, a company might have issued 100 £1 shares and have a share capital of £100. If it issues a further 100 shares at £0.50 and the new subscription is taken up, then the share capital of the company becomes £150 with 200 shares in circulation. The average price of a share for a shareholder who held shares before the new issue drops from £1 to £0.75.
Why a right of first refusal clause might be important to include in a shareholder agreement?
The issue of new share capital affects the value of the investment of every shareholder. Yet the decision to issue is not one that all shareholders might make, or be able to control. Sometimes, it may not be the shareholders who make the decision at all, but rather the directors.
A majority shareholder might be able to control shareholder decisions; but he might not be able to prevent the board of directors authorising the issue of new capital and reducing his voting power as a shareholder on matters important to him. (He might have limited power on the board because he might not be a director or he might only control one or few of many board seats).
A minority shareholder might be powerless to control whether a share issue happens. The effect might be to further reduce his relative holding below the limits at which the law gives him automatic rights to do certain things. He may find himself edged out of the company without being able to prevent it.
In either case, the inclusion of a right of first refusal would allow the shareholder to maintain his power.
Mechanics of the clause
Usually, a limit is put on the number of new shares that can be bought so that a shareholder can maintain his ownership percentage, but not strengthen his position unless another shareholder decides not to (or cannot) exercise his right.
The company could make it easier for shareholders to take up their right by allowing them to buy the shares at a discount to the price external buyers would pay.
Should you include this clause within your agreement?
A right of first offer clause is not common in shareholder agreements where the company is small (and/or new). That is usually because shareholders are also directors, and all owners have similar sized stakes.
You might consider the inclusion of the clause if you think that your company will be seeking external equity investment in the future, but it is likely that any new investor, particularly an institutional one, will insist on creating a new shareholder agreement.