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Preventing the dilution of shares

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Lawdit Solicitors - Expert Author

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Written  on 18 December 2013 

Dilution of shares means a reduction, either in value (economic dilution) or relative ownership (percentage dilution). If a company issues new shares and one shareholder doesn't buy more shares from the new issue, then the number of shares he owns as a percentage of the total number issued decreases. One of the most illustrating cases on dilution of shares involves one of the directors of Facebook, Eduardo Saverin, who was ousted from his position as Finance Director, by the other board members allegedly diminishing his share capital from 34% to 0.03%.

Why should we be aware of the issue of shares of a company? After a dilution, shareholders will lose their power to control the company simply because it will cause a variation of their class rights. For example, it will reduce the relative power that a shareholder has in setting the direction of the company and controlling its operation. It dilutes the shareholder’s ability to control issues that require shareholder approval which have a greater impact on the value of his investment.

Thus, the Company’s Act 2004 (CA 2004) has always protected this kind of situation by giving provisions to minority shareholders to prevent dilution.

Directors are restricted in their right to allot shares. Section 549 of CA 2004 stops the directors from issuing shares to anyone unless they are authorized to do so in the articles or by shareholders passing an ordinary resolution (section 551). This ban also covers an agreement to issue shares and the grant of options that will result in a future issue of shares. We should note that this rule does not apply to a private company with only one class of share.

The most famous provision is called the pre-emption rights. Indeed, Section 561 obliges a company to offer new shares first of all to its existing shareholders in the same proportions they already hold shares. It upholds shareholders’ right to be protected from dilution if they are willing to pay the price asked for the new shares. Such an offer must be open for at least 21 days, but some conditions are required: the statutory pre-emption regime does not apply to certain shares, including bonus shares, shares issued partly or wholly for non-cash consideration, and shares held under employees’ share scheme.

Section 561 can be disapplied, along with section 549, either in the articles or by a shareholder vote, though only by a special resolution (in order to pass a special resolution 75% of shareholders present at the meeting at which the resolution is proposed must vote in favor).

Pre-emptive rights can also arise from the company’s articles of association or under the terms of a shareholders’ agreement. Both Table A (for companies registered before 1 October 2009) and the Model Articles (for companies incorporated after 1 October 2009) include pre-emptive provisions. Any new shares issued for cash have to be offered to existing shareholders first. But it does not apply to new issues of shares that are allotted as wholly or partly paid up or issued for a non-cash consideration. This regime can be disapplied and replaced by a bespoke procedure for allotment.

To conclude, the shareholder agreement generally sets out the limits, scope and position of each shareholder, which will minimize any issues later. To avoid Saverin’s situation, you must be careful to always read the clauses in the shareholder agreement and to not just sign it based on trust, because you will need to rely on those provisions if any issues do arise in the future.


About the Author

Lawdit Solicitors offer services and advice for litigation, commercial contracts, Intellectual Property and IT legal agreements. We are experts in commercial law with a heavy emphasis on Intellectual Property, Internet and e-commerce law. Lawdit is a member of the International Trademark Association, the Solicitors' Association of Higher Court Advocates and we are the appointed Solicitors to the largest webdesign association in the world, the United Kingdom Website Designers Association.



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Article Published/Sorted/Amended on Scopulus 2014-01-24 12:41:10 in Legal Articles

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