Corporate finance: New equity becomes an issue

Unlike equity markets in most other parts of the world, pro rata pre-emption rights have long been a cornerstone of company law and London stock market practice.

Last year, Paul Myners submitted a report to the DTI on the impact of pre-emption rights on companies seeking to raise finance for innovation and growth. He concluded that pre-emption rights should remain, but that a ‘Pre-Emption Group’ be established to produce guidance on when it would be permissible for such rights to be disapplied. The group was formed under the umbrella of the Financial Reporting Council and produced its statement of principles in May.

The group’s statement of principles has been designed to help the case-by-case dialogue between companies and shareholders; the group will continue to monitor the development of best practice and will issue an annual report, but will not intervene or comment on specific cases.

Principles

• The overarching principles in the statement make clear that pre-emption rights are a cornerstone of UK company law, and as such they can only be disapplied by a special resolution of shareholders. But a degree of flexibility may be appropriate where it would be in the company’s and shareholders’ interests to issue shares on a non-pre-emptive basis.

• Companies have a responsibility to indicate as soon as possible their intention to disallow pre-emption rights and to enter into dialogue with shareholders.

• Shareholders, in turn, have a responsibility to engage in dialogue with companies and to consider each non-pre-emptive equity issue on its merits, using the usual investment criteria. Likewise, shareholder advisory services should listen to what companies have to say in such circumstances.

The principles are intended to apply to non-pre-emptive share issues for cash by companies listed on the main market. AIM-quoted companies are encouraged to apply these principles, though investors recognise that greater flexibility is likely to be justified in the case of such companies.

Routine, non-controversial requests are more likely to be agreed to by shareholders if such requests represent no more than 5% of the ordinary capital in any one year.

In the absence of suitable advance consultation and explanation, companies should not issue more than 7.5% of their ordinary share capital for cash in any three-year period, the statement says.

Price discount

Pricing of the new shares is a relevant consideration, and an equity issue priced at more than a 5% discount is not likely to be regarded as routine. (While the size of discount in a conventional rights issue is almost entirely irrelevant (save for some capital gains tax issues for shareholders who choose not to exercise their rights), for a non-pre-emptive issue, the greater the discount the greater the dilutive effect of the issue.)

Companies should ensure that they are raising capital on the best possible terms, particularly if the capital-raising is to enable a transaction that is likely to enhance the company’s share price.

The statement emphasises that the purpose of these principles is to ease the granting of authority below the figures stated above and not to rule out approvals above them. Requests which would exceed these levels should be considered by investors on a case-by-case basis.

Membership

Membership of the Pre-Emption Group included finance directors from Cambridge Antibody Technology plc, GUS plc and AMEX plc, as well as a number of institutional investors and investment banks. The chairman is Scott Dobbie.

PRINCIPLE ISSUES:

While it clearly isn’t possible to define all the circumstances in which investors might be willing to allow a non-pre-emptive equity issue to proceed, the principles suggest some general considerations that are likely to be relevant.
These are reproduced below:

The strength of the business case: In order to make a reasoned assessment shareholders need to receive a clear explanation of the purpose to which the capital raised will be put and the benefits to be gained. For example, in terms of product development or the opportunity cost of not raising new finance to exploit new commercial opportunities – and how the financing or proposed future financing fits in with the life-cycle and financial needs of the company.

The size and stage of development of the company and the sector within which it operates: Different companies have different financing needs.
For example, shareholders might be expected to be more sympathetic to a request from a small company with high growth potential than one from a larger, more established company.

The stewardship and governance of the company: If the company has a track record of generating shareholder value, clear planning and good communications, this may give shareholders additional confidence in its judgement.

Financing options: A wide variety of financing options are now available to companies.
Companies should explain why a non-pre-emptive issue of shares is the most appropriate means of raising capital, and why other financing methods have been rejected.

The level of dilution of value and control for existing shareholders
The proposed process following approval: Companies should make clear the process they would follow if approval for a non-pre-emptive issue were to be granted. For example, how dialogue with shareholders would be carried out in the period leading up to the announcement of an issue.

Contingency plans: Company managers should explain what contingency plans they have in place in case the request is not granted and the implications of such a decision.