Pre-emptive rights (and why it’s important for your startup)

Pre-emptive or pre-emption rights, aka right of first refusal is a crucial right given to an existing shareholder in a private company. In this post, we’ll run through some high level issues on why this pre-emptive rights is important and what founders should know before you start your next funding round for your startup.

How does pre-emptive rights work?

By default, every shareholder now has a pre-emptive rights to acquire new shares in the company unless it is waived by such shareholder. Initially, this right needed to be incorporated in an agreement (eg, a shareholders agreement), but the recent revisions to the companies law in Malaysia in 2017 made pre-emptive rights a “default” right that applies to all shareholders in a private company.

On a side note, this pre-emptive rights does not apply to shareholders in public listed companies (see this op-ed discussing why pre-emptive rights is crucial for shareholders investing in public companies such as governance issues).

Why should I care about pre-emptive rights?

So what does this all mean anyway? As a founder, before you can bring in any outside shareholder (eg, investor or angel) to your startup, you must first offer the shares to the existing shareholders. The usual offer will entail the opportunity for the existing shareholder to maintain his current shareholding ratio in the company (also known as ‘pro rata’ in Latin) with the rest of the existing shareholders.

The basis for pre-emptive rights is to allow an existing shareholder to preserve his voting power in a company by entitling him to buy a proportion number of shares in the new shares issuance.

In practice, financial investors like venture capitals or corporates may even request that you include allotment of new shares as another reserved matter list. In other words, in addition to getting the usual paperwork done by the company secretary such as preparing the necessary board and shareholders resolution for the new shares, you also need to get the investor to agree on a new funding round as it is part of a reserved matter.

Also, in my experience, it can be challenging to get the pre-emptive rights waiver if you’re dealing with “difficult” shareholders (hence, why it’s crucial to onboard good shareholders in the first place!). Let’s say you may have issued shares to an initial employee and the employee may have left the company on a bad term. It can be hard to find the ex-employee to get the necessary waiver unless you’re still on speaking terms. Or else, he can make your next funding round difficult.

The usual best practices when it comes to dealing with pre-emptive waivers in a company

The law is silent on how the offer should be made to the existing shareholders. In other words, so long as the company’s board can demonstrate that the necessary notices have been issued to the shareholders (eg, issuing letters or emails to the shareholders) with the appropriate time frame (like 7 days to respond) or the shareholder can be deemed to have waived the right, this pre-emptive rights can be satisfied.

So, even if a current shareholder decides to ignore such notice by a company after the notice period has lapsed, the company’s board can continue to issue the new shares to the third party.

Can I waive or limit pre-emptive rights for future funding rounds for my startup?

The quick answer is yes, so long as you can get the new shareholder (eg, the investor) to agree to waive their future pre-emptive rights.

Let’s take a look at an equity crowdfunding campaign round for example. Nowadays, more and more startups in Malaysia are raising funds by hosting their companies on equity crowdfunding campaigns. In practice, the shares are held by a nominee company formed by the crowdfunding operator. In other words, your shares as a crowdfunding investor will be held via a nominee set up.

To make things easier for the company to raise future funds, it is common for the shareholders agreement to incorporate a clause upon which a crowdfunding investor agrees to waive his pre-emptive rights for future crowdfunding campaigns. Additionally, under the companies law, you will also need to amend the constitution to include the wordings to allow for the company to initiate future shares issuance without giving any pre-emptive rights to subscribe for new shares to the existing shareholders.

In practice, it can get messy especially when you may have a certain group of crowdfunding investors that may want to have a right to participate in future funding rounds. So it would be a good practice for you to keep your crowdfunding investors. Currently ,there is no requirement imposed by the regulator to provide regular reports and so on but it may be a good idea if you start this habit because it is customary to provide regular updates to your investors.

What else to know about pre-emptive rights?

Now that you know pre-emptive rights are embedded in the companies law, you should take note the timing when you want to do your next funding round especially if you have a lot of shareholders in your company (like more than 5) in terms of organising the logistics to get the necessary waiver letters in place before you can proceed with the next step to issue the new shares to the new investor.

In practice, this can be satisfied easily by electronic signatures platforms like HelloSign orDocuSign. You can even get the shareholder to print out the letter and sign using a wet signature and scan back the signed copy. So long as there is proof that the waiver has been signed by the relevant shareholder.

In practice, it can be challenging if your company secretary is a traditional guy that may insist on a physical signed copy (which is also a sign that you should consider changing your company secretary after the funding round is completed).

Can’t find the article covering the topic that you’re currently finding for your startup? I’m always figuring out new topics to write about on this blog. Feel free to drop me a note using the contact form, so that I know what to write about next time.