Right of First Refusal and Co-Sale Agreement
Right of first refusal or ROFR is a contractual benefit that gives top priority of engagement to the right holder stakeholder in a transaction.
Business contracts are the cornerstone of every transaction. Their basic purpose is to outline all the terms mutually agreed upon between stakeholders. These terms primarily set out the deliverables such as the number of assets exchanged, the money involved, payment terms, and details of the stakeholders. Besides this, provisions are made to preserve the rights of stakeholders as well. Right of first refusal and Co-sale rights are some of these features that ensure existing stakeholders get preference before assets are transferred to a third party.
Right of First Refusal or ROFR
The right of first refusal or ROFR clause when included in a contract is a buyer’s delight. It entitles the existing stakeholder to a ‘first right’ before the deal opens up to a third party. Let’s see how this works.
What is a Right of First Refusal (ROFR)?
Right of first refusal or ROFR is a contractual benefit that gives top priority of engagement to the right holder stakeholder in a transaction. Only when the stakeholder refuses to make the first move, the deal can be opened to a third party. ROFR this way assures that the asset holder does not lose rights over their holdings. This clause is commonly used in real estate, joint ventures, sports, entertainment, publishing houses, and startup scenarios. Here is an example of how ROFR plays out in some of these sectors:
- ROFR in real estate – Real estate is a classic scenario where the right of first refusal clause plays out in full strength. Let’s take an example of a tenant who has taken a property on lease. It is quite normal for this tenant to have options open to buy this property at some point in time instead of moving out in case the property goes out on a sale. In this situation, the tenant demands a ROFR clause that entitles them to have the first right on the property before the owner opens it up to the market.
- ROFR in a joint venture – A joint venture is another typical scenario where the right of first refusal clause plays out to its strength. In a joint venture, partners hold the ROFR right. This enables them to have first rights over the shares of an existing partner before those are offered to an external stakeholder. This is a safe way to preserve the integrity of the company. It is much better if an existing partner exercises the right to purchase additional shares instead of inviting an external third party.
Benefits of having ROFR
As we see, the right of first refusal is quite a nuanced clause. If drafted well into a contract it benefits the right holder (both an individual and the company) in every possible way. Here are some obvious benefits of this clause:
- For an individual holding ROFR – An individual holding the right of first refusal can bank on it just like an insurance policy. The asset they hold cannot go out for sale without consulting them. As long as the right holder adheres to all the restrictions, the ROFR clause protects their claim on the asset.
- For a company holding ROFR – A company holding ROFR benefits from it in a very secure manner. Especially in the case of startups, the right of first refusal clause allows the company to have control over its cap table. Private shareholders cannot transfer/sell shares as they please. In case a shareholder plans to exit, the ROFR entitles the startup to have the first rights over the shares before they are offered to a third party. The startup most often chooses to buy back these shares. This is important because:
- A startup thrives on innovation. All shareholders have access to the business innovations and growth strategies of the company. Minimizing external buyer interest is important to protect the integrity of the business.
- It is better than existing stakeholders and investors buying back the shares of an existing partner.
- If an investor is truly interested in the company, minimizing private share sales increases the chances of the same buyer to return as an investor in the next funding round. This is a much better scenario because a proper funding round will bring in funds to the company. But a segmented share sale only benefits the existing shareholder.
- Preventing unregulated share sales by existing shareholders minimizes the chances of entry of an investor interested in a competitor. Without a ROFR, a third party can purchase a few shares of the existing partner and still gain shareholder rights. This is a dangerous situation for the integrity of a startup’s intellectual property.
How does a Right of First Refusal work?
Before getting into the detailed workings of the ROFR, it is important to understand that the right of first refusal is an option provided to the right shareholder. They are not obligated to use it during an asset transaction. This is how it works:
- When company founders decide to sell shares, as per the ROFR they are obligated to prioritize the company and extend the first rights. This offer needs to be the same as offered to the third party.
- In case the company chooses not to exercise ROFR, the next offer must be made to the venture capital investors. When there is more than one investor, each one would exercise their ROFR on a pro-rata basis. In case, one of the investors chooses to opt-out, all others again have the chance to purchase these left-out shares on a pro-rata basis. This is otherwise known as the ‘right of oversubscription’.
- In case both the company as well as the VC investors chooses not to exercise their rights, founders are free to proceed with the third party.
Despite its strengths, the right of first refusal clause may have a flip side too. To ensure that stakeholders do not exploit their rights, it is best to design a ROFR in consultation with an attorney. Normally, certain conditions are included in the contract that limits the overreach of the ROFR clause. Here are some commonly used conditions:
- The extent of ROFR – An ROFR clause is typically time-bound. The right holder can exercise their claim on the property only until this period. Even during this period, the right holder has a limited time to decide on their claim. A right holder cannot indefinitely sit on an offer bound by the ROFR clause just because they have the first rights. In case the period lapses, the property/asset/shareowner is no longer obligated to consult the right holder before approaching a third party for sale.
- Triggers of ROFR – A contract with the right of first refusal clause must also specify the conditions under which it is triggered. Many times, in the case of assets, they are used to raise loans. This is a typical scenario where a ROFR will not apply. A ROFR is triggered only during an asset sale. Similarly, based on the nature of the asset, the contract must mention the grounds on which a right holder can exercise their claim.
- Exclusions and transfers of ROFR – This is another important aspect to be considered before drafting a right of first refusal clause into a contract. Usually, ROFR rights are not transferable within family members. However, in case an asset changes hands after the original right holder forgoes their right over it, the new owner may be granted the new ROFR on the same asset.
Negotiation tips for ROFR
With the pros and cons in place for ROFR, there are still grey areas that should be discussed to make a ROFR clause the most efficient. If Founders are not careful, sometimes these gaps can result in an overreach. Here are two examples to consider:
- Founders could make it a point that stakeholders choosing to exercise the ROFR clause must exert their right on the entire asset/shares. They should not be allowed to choose in parts. Thus a deal is either completely absorbed by the stakeholder or let off. There is no chance of diluting the package on sale.
- Founders could ensure that ROFR does not apply to the category of stocks already owned by the stakeholder. For example, preferred stocks.
Right of First Refusal vs Right of First Offer
The right of first offer or ROFO is an alternative to the right of first refusal. ROFO is simply a clause that allows the right holder to make the first offer on an asset. Similar to ROFR, the right of the first offer is also time-bound and used in various situations especially in the real estate and startup scenarios. The seller can either choose to accept or reject it. But there is a basic difference between ROFR and ROFO –
- Right of first refusal or ROFR is driven by the asset seller and favors the right holder/buyer. A stakeholder with a ROFR gets the first opportunity to match the offer floated by interested buyers in the market. The asset seller in this case must offer the best deal first to the ROFR holder. ROFR is thus a great way of keeping potential buyers at bay as not many parties will be interested to negotiate a deal, only to be offered first to the ROFR holder.
- Right of the first offer or ROFO is driven by the right holder but favors the asset seller. In this case, the ROFO holder can only make their first offer without any involvement with the pre-existing offers floated in the market. Thus the seller is at the advantage of acknowledging the offer of the ROFO holder and still reserves the right to refuse and choose the best one in the market.
Sample of ROFR
Now that we have a fair idea about the right of first refusal and how it works in different scenarios, here is a sample agreement that details all the particulars of such a document.
The ROFR and ROFO discussed so far involve the majority of stakeholders and the asset holder. But what about the minority stakeholders? Is there a clause that might preserve their rights on an asset? Let’s take a look.
What are co-sale rights?
Co-sale rights are a clause designed specifically for minority stakeholders. It is otherwise known as the ‘take-me-along’ or ‘tag-along rights’. As it is, we know that finding buyers for shares of a private company is a very difficult task. In addition, if the stakes are held by a minority shareholder, the chances of finding a suitable buyer only for those little chunks of shares are almost negligible.
Why is it important?
Since the majority of stakeholders are the ones with deep pockets, it is quite natural that they hold a diversified investment portfolio and have better business networks. As a result, it is easier for them to secure a profitable deal in case they want to sell their shareholdings. This is something minority shareholders fail to do. Just owing to co-sale rights, minority shareholders can capitalize on profitable pricing managed by the majority stakeholders.
How does co-sale rights work?
Let’s imagine a startup just raised a round of VC capital. Two investors come off-board a VC firm holding 80% stakes and an individual investor holding 20% shares. Let’s say the VC firm stays on with the startup for the next 6 years after which it plans an exit leaving the company strategically and financially much stronger. When the VC firm strikes a deal to sell its shares at $75 per share, as per the co-sale rights the individual investor can also join the firm and offer their 20% at $75. This is the simplest working of the co-sale agreement. Based on the nature of the deal, the conditions of the agreement would become intricate.
Sample co-sale agreement
Penalties for violating contract terms
ROFR is a contractual right. Thus violations of it come under the preview of the contract law. Like all violations of contracts, ROFR violation attracts penalties both in terms of monetary compensation as well as entitlements for specific damages.
Want to incorporate a right of first refusal for your company?
As we see, keeping track of majority and minority stakeholders is an important aspect of running a business. To issue, manage, and track company shares is a cumbersome job and must be handled with precision. Since all these transactions are legally binding, the smallest of errors can cost the company a fortune. Thus it is best to automate equity distribution using sophisticated software such as Eqvista. With years of experience across diverse industries, Eqvista is the perfect automated tool for all your equity needs.