The board is contemplating an equity raise. The brokers and CFO talk in respectful terms about preserving pre-emption rights and what this means for how they raise the new capital. Maybe you, as a new non-exec, are sitting there wondering what is this all about and why is it so important?
However all directors should understand these issues, particularly as shareholders take this very seriously, and may well hold the whole board to account on this.
This article focuses on publically listed companies, as most private companies will have tighter rules on bringing in new shareholders anyway.
What are pre-emption rights?
Pre-emption is simply the right for existing shareholders to buy new shares before others can. For a private company, this would ensure that the board couldn’t issue a large tranche of shares to another party and so dilute an existing shareholder’s holding and voting rights without the latter’s approval.
For a liquid publically listed stock, shareholders will expect pre-emption rights for any significant share issue. Usually the focus is on any price discount being offered on the new shares. Take an example: A company with a share price of 400p places a 1 for 2 share issue at 300p (a 25% discount), without first offering it to existing shareholders. On a pro-forma basis, the existing shareholders would lose 8% of the value of the holdings as the price moves to the blended average price of £3.67. Meanwhile the new shareholders get an immediate gain of 22%. So you can see why the existing shareholders would be pretty cross about it.
Pre-emption rights mean that any significant new share issue for cash should be offered first to existing shareholders in proportion to their current holdings. This means that if they take up these rights, they would not be disadvantaged, as they would get their fair share of any discounts offered.
A new share issue might also be launched in order to provide equity (as opposed to cash) for an acquisition, with the new shares being offered to the target company shareholders. In this case pre-emption would be impractical, so the issue is likely to be whether the price effectively being paid is a reasonable one.
Rights Issues, Open Offers and Placings
Rights issue: All shareholders are offered the new shares in proportion to their holdings, usually at a significant discount to the prevailing share price. In the above example, a 1 for 2 rights issue would simply mean that all shareholders are offered 1 share for every 2 shares they currently hold. This delivers perfect pre-emption, and so is the more popular mechanism for shareholders. A shareholder who doesn’t take up their rights can receive some of the discount value without investing more cash, as their allocated shares are then sold on the market and the price difference remitted back to them. For these reasons, the rights issue is generally the default mechanism for boards when they consider raising equity.
Open Offer: This is similar to a Rights Issue, but any shareholders who do not participate won’t receive any value for any allocated shares that they do not take up. It therefore adds more incentive to existing shareholders to participate whilst retaining full pre-emption.
Firm placing: This offers no pre-emption. The company will have presold the shares to one or more new investors, likely at a discount. This means that other shareholders will not be able to access any of the discount and may feel aggrieved. However, it enables a company to bring in new investors to the equity issue, which is important if it believes that existing shareholders would not be prepared to provide all the extra capital requested.
Placing and Open Offer: This retains partial pre-emption but also enables a company to bring in new investors as well. Existing shareholders are offered a proportion of the new shares in the open offer (pro rata to their holdings), but can also apply for more shares. If demand from existing shareholders exceeds the total allocated in the open offer, then the company may claw back some of the shares allocated to the placing. This therefore gives full pre-emption in the open offer, and partial pre-emption in the placing.
There are other mechanisms and this can become much more complex than this, but these are the essentials.
How does a board decide which mechanism to use?
The key issue is generally whether the board is sure that existing shareholders will buy all, or nearly all, of the new shares. A board needs to take account of pre-emption, but is even more focussed on making the share issue a success. It is not generally in shareholders’ interests for an equity issue to fail, with all the question marks that this would raise about the company.
You might say that companies usually get an equity issue underwritten, so they are sure of receiving the cash. However, by definition, underwriters will only support an issue if they think it will be almost fully subscribed. It is an insurance policy not a subsidy! The underwriters may also force an even bigger discount in the offer/rights share price in order to reduce their risk.
So if a company feels that it needs to bring new shareholders in to make the issue a success, then it is likely to move towards some variant of a placing, possibly combined with an open offer to provide some pre-emption. The board has to reconcile the desires of some shareholders, who insist on preserving pre-emption, with its need for certainty that the shares will be pretty much fully subscribed.
What do shareholders want?
In the UK, the Pre-Emption Group (representing listed companies, investors and intermediaries) clarified its principles in March 2015;
General authority: General meeting resolutions to give the board a general authority to disapply pre-emption are looked upon favourably only for share issues;
- For up to 5% of the total share capital; and
- For up to 10% of the total share capital, provided that anything over 5% is for a specific acquisition or capital investment (fully disclosed at the time).
Subsequent share issues:
- These should be for no more than 7.5% of total share capital over a rolling 3 year period; but
- If more than 7.5% then only if either shareholders have been consulted, or the reason for the raise was stated with the last general meeting resolution.
- The 7.5% restricts only the non-pre-emptive element of any share issue. If there is a mix of pre-emptive and non-pre-emptive elements, it applies only to the latter.
- Any discount offered to shares issued non-pre-emptively is a matter of concern and, except in exceptional circumstances, should be limited to 5%.
- The 5% discount may be larger for underwriting provided that it is believed to be a backstop, which will not be drawn upon.
Requesting a specific disapplication:
Companies are expected, if possible, to inform shareholders and to discuss with them, any intention to initiate a cash raise, particularly if it is to be non-pre-emptive. Shareholders will expect a strong business case for the raise, covering alternative sources of finance, consideration of the cash raising mechanism, requirement for avoiding pre-emption, and demonstration of good corporate governance and value enhancement.
Clearly not all shareholders can be consulted, so there is recognition that this is really aimed at large, usually institutional, shareholders. Care needs to be taken as to when any consultation effectively gives the shareholders inside information.
Some shareholders adopt a very purist line on pre-emption. Their corporate governance team may vote their shares against any capital raise which is not almost completely pre-emptive. This can be despite the fund manager being supportive of the board, having understood the need to get new shareholders and to ensure the issue is a success. They may well still buy the shares, even in a non-pre-emptive element. A vote against therefore may be largely symbolic, but given that this is a special resolution, requiring 75% majority, it wouldn’t take many symbolic votes to threaten the issue.
Pre-emption is all about making sure that existing shareholders are not disadvantaged by equity being issued cheaply only to certain shareholders or new investors. This is a highly complex area, and this article summarises only the key points. In a real situation, lawyers and bankers will be on hand to advise in detail. The key point is for boards to be aware that shareholders take a very close interest in pre-emption and directors should understand how the different equity raising mechanisms affect this.
- Pre-emption is about protecting existing shareholders from issuing new shares to others without themselves being offered those shares, particularly when the offer is at a discount.
- Rights issues are the most perfect form to offer pre-emption, but are less appropriate if the company believes that it needs new investors.
- Placings can enable companies to bring in new investors, and can be combined with, at least partial, pre-emption.
- There are quite specific rules on how a company can disapply pre-emption, both as a general authority and for a specific fund raise.
- Large shareholders like to be treated properly and consulted as far as is practical, preferably in advance of any final decisions on a capital raise.
- Although these rules are mostly applied to share issues for cash, increasingly shareholders are concerned about acquisitions for shares being value-generative. Boards should ensure that these are well justified and backed by good governance.