This article is written by Amresh Chandra who is pursuing a Diploma in M&A, Institution Finance & Investment Laws (PE & VC Transactions) from Lawsikho.

Introduction

The purpose of an agreement is to define the subject matter and the associated duties and obligations of the parties along with protecting their rights and interests and to reduce the possibility of any conflict at a later stage. A shareholder’s agreement is entered to reduce the possibility of any dispute between the shareholder’s and the founder or the investor and the investee. The right of first refusal clause in a shareholder agreement describes what will happen when one of a shareholder or investor wants to sell its stake.     

This right primarily protects the company and it’s existing shareholders from sale of shares to a competitor company or such parties with whom the company doesn’t have friendly relations. When some of the shareholders wish to sell their share, a clause in the shareholder’s agreement should state that the shareholders who wish to sell their shares have to show the right to match an offer received from a third party. This is known as the right of first refusal. The right of first refusal clause guarantees that, as the shareholder or investor leave, the existing stakeholders has the first option to buy the stake of the investor who is intending to sell his share. 

Importance of Right of First Refusal (ROFR)

The ROFR clause is found normally in commercial agreements and it provides security in commercial and business perspective. ROFR is a contractual right annexed by the promoter/founder of the company to it’s investors/stakeholders which create significant impact on the business. Small companies normally have small number of investors/shareholders and here this clause plays very important role in case any investor wants to exit. A ROFR right can also be incorporated in the lease of commercial property agreement, which offers the tenants the first right to purchase or refuse the property after the end of the lease period. The power of the right of first refusal clause fully works on the terms and conditions agreed between the parties before in the agreement. The primary things considered while drafting these rights, such as these rights can only exist in certain circumstances, or only selected shareholders may have the right to buy those shares. That’s why the first refusal is an integral part of the shareholder agreement.  

Rational to incorporate Right of First Refusal in SHA

It is imperative to be called the term ROFR as ‘last look provision,’ because it provides the right to the remaining shareholders to purchase the stake in case of any share sale by any of the investor who has invested his capital in the venture and want to exit among the shareholders. The ROFR clause can also be used in variety of agreements as an exit option and to the remaining shareholders. Therefore, ROFR becomes a mandatory right in the agreement from the investor point of view and it also provides benefit to the rest of the stakeholders. The rational to consider Right of first refusal (ROFR) as a clause in a commercial agreement are discussed as below:

1. The Right of first refusal clause provides a cushion to the remaining non-selling partners in a shareholder agreement and to Control the process of inducting a new shareholder while control the liquidity of the selling shareholder. By this way, this clause provides exerting control to the existing shareholders over the company.
2. ROFR provides a balance of power between the stakeholders because it benefits the minority shareholders too and during the event of stake sale by the majority partner, the interest of minority should not be curtailed. 
3. The right of first refusal can be drafted and amended as negotiated between the parties to the agreement and incorporated accordingly as specified by the investors. 
4. It helps the investor/buyer to retain the right to purchase the shares later. When the promoter of the company offers ROFR clause to the investor, it plays a better negotiation tool and attracts the investor. They presume that the promoter really cares and protect their investment and will give priority during share sale at later stage by the majority shareholder. ROFR enables the buyer’s retaining potential to purchase the shares in any future event of share sale. 
5. In case of startup funding, by applying ROFR clause existing investors block the inducement of external investor for investment. During the event of any share sale the same deal being offered to the current interested shareholder to prevent their stock from being depleted.
6. It could provide a fast and hassle-free option to the stakeholder intending to sell and exit from the business after taking their investment and profit.

Demerits/Shortcomings of ROFR

The ROFR clause has many benefits to the investors but at the same time the disadvantages and complexities associated in execution with this clause cannot be ruled out. With the execution of this clause, the intending seller will have to provide an opportunity to the remaining stakeholders by serving a notice of specific duration usually 30 days. By that period the stakeholders have to respond to the selling shareholder. After the enforcement of ROFR clause the same terms and conditions which govern the share sale for the selling stakeholder will prevail upon the remaining partners of the company. By virtue of the ROFR clause in the shareholders agreement, new investors deter to invest in the company. However, this clause does not discourage other investors from selling their stake to a third party when the remaining shareholder’s can’t afford to buy the stake of intending seller’s share. It can be described in other words as ROFR shall provide an authorization to the investor to first buy the stake during the event of any share sale but, it does not provide any right to prevent others when he himself/herself cannot afford to buy the selling stake.

Without proper valuation of the company, coming to a definite conclusion of the share price in the agreement for an indefinite period of time makes the share price cheaper than the current market value of the company and it ultimately reduces the share price which creates huge and impact profitability while share sale. Another good reason not to consider ROFR is that out of the multiple stakeholders in a company only the ROFR holder can execute and exercise this right. This clause holder cannot pass this right to anyone without prior consent of the founder of the company; hence it’s a restrictive clause.  

Salient Features of Right of First Refusal

The ROFR clause clearly provides definite time frame and by that time only a party can exercise its right of first refusal. The intending seller should inform the remaining investors by way of notice about an offer to the holder of ROFR stating the number of days within which the holder can execute the right.

In the notice to the remaining partners, ROFR provisions are clearly mentioned and elaborated which party should decide the terms and conditions under this offer.

All valid agreements should contain the ROFR clause. While negotiation, when one party gets the right to exercise ROFR, the other party to the contract may bargain anything which protect their legal interest.

During the negotiation round under the ROFR clause what will be the consideration whether it would be cash or kind in exchange of shares being discussed and negotiated, cash is not the only criteria. 

It totally depend upon the parties whether they want the transferability of ROFR clause to the other party or not. ROFR clause can transfer with the investment, and when the present investor sells his/her stake to the new investor then, the new investor may have to provide the present investor the right of first refusal.

It has some exceptions which specify the right and ROFR does not apply to certain situations.

It must be clearly specified and described about the circumstances to all parties when the ROFR clause will come into force. Again the subject matter for which this clause is defined should be described in length.

It’s undoubtedly true that the right of first refusal is a contractual right that can create enormous impact upon the business and the exiting partner as well as the remaining partners. Though, the interpretation and drafting of this clause along with the narration during the negotiation round plays a pivotal role in execution. Therefore, while incorporating ROFR clause in an agreement the attorneys sincerely adopts simple and concise legal terms without ambiguity and describe its importance and usefulness to the parties.

Conclusion

The Right of first refusal clause provides certain specific rights to the shareholder under which an investor can purchase additional shares in a company before the same is offered to any new purchaser. It restricts the inducement of third person in the company and provides additional control to the right holders during share sale.

In order to make it effective and ensure its proper execution there should be valid contract between the parties. To make the agreement exhaustive and investor-friendly ROFR clause being incorporated in variety of contracts and transactional agreements such as shareholders agreement, property lease and franchise agreement, etc. The stakeholders in an agreement need to understand the importance and demerits of this clause. Attorneys and lawyers should draft and describe it in better way to derive the maximum benefit of this clause which protects the legal interest in a profitable manner.