This article is written by Prince Pathak, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from lawsikho.com.

Introduction

Agreements always lay out how the business seems to be run and what happens when one of the shareholders or investors wants to sell its shares or real estate. In real estate investment leasing and the purchase and disposal of businesses, the first offer/bid and the first refusal are important contractual factors.^[i] The first refusal provision guarantees that, as the shareholders or investors leave, the holders have the first option to buy the share or real estate of the founders. For example, In the shareholders agreement when the shareholder of a company intends to sell its shares, the selling shareholder has to provide a notice to all the shareholders in the company. The other shareholders in this situation have the first opportunity to purchase or refuse the shares, and this opportunity is known as the first refusal. In this article, the author tries to explain the various aspects of the Right of first refusal in a contract with its benefits and drawbacks.

The right of first refusal also often found to be in a real estate transaction. For example, Mr. X is the property owner that he wants to sell to the purchaser Mr. Y for 100 crores under specific terms and conditions. However, Mrs. S has the right of first refusal in a contract to purchase the property of Mr. X. So, before Mr. X. can sell the property to the purchaser, Mr. Y, he must first offer it to the holder (ROFR) Mrs. S under the same conditions as those provided by the purchaser Mr. Y. And if holder Mrs. S. exercises the right of first refusal, then purchaser Mr. Y will have no right to acquire that property.

Why is a first refusal important?

It is crucial to understand the importance of the first refusal in the agreement. The first refusal clause is usually found in the commercial agreement, and the right of the first clause provides more security to the business. The first refusal is a contractual right granted by the owner that can create a significant impact on the business. Small businesses usually do not have a large number of shareholders; it is especially valuable for the Small Business Shareholders Agreements to include a “first refusal” provision^[ii]. Venture capital firms and other businesses also have the first refusal to get the highest deal on securities or whole businesses. ROFR (Right of first refusal) protects the business from the third party who may have less business experience in that particular area. A ROFR right can also be present at the lease agreement, which provides the tenants the first right to purchase or refuse the property when the lease comes to an end. The power of the first refusal clause completely works on the terms which have been agreed before in the agreement. Many things can be taken care of while forming this right, 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.

Reasons to consider using a first refusal

ROFR is also known as ‘last look provision,’ and it provides the right to have a last look at a deal. The ROFR clause can also be used in different types of agreements. Nevertheless, ROFR is not a mandatory right in the agreement, but it is beneficial to consider the Right of first refusal (ROFR) for the following reasons:

1. The Right of first refusal clause gives benefit to the other non-selling shareholder in a shareholder agreement to Control the process of bringing a new shareholder while upholding the liquidity of the selling shareholder. In this way, the Right of the first refusal clause gives an existing shareholder an exerting control over the company.
2. The right of first refusal is beneficial to maintain the balance of power between the shareholders because Right to the first refusal is beneficial for minority shareholders. 
3. The right of first refusal can be modified or built according to an individual or personal specifications. 
4. With the help of the ROFR clause in the contract, owners can easily attract the tenants; this can allow the sale process quicker. It helps the buyer to retain the right to purchase the property later.
5. ROFR enables the buyer to retain the purchasing of the commodity at a future date.
6. Startups with the first refusal can block an external bidder from joining when the current shareholder agrees to sell his stock. They can sell the same deal to the current shareholder to prevent their stock from being depleted.^[iii]
7. This could speed up the selling process and sellers to save money and resources, particularly in the real estate business.

Reasons to consider not using the first refusal

The first refusal clause also has some disadvantages because of its complexities. It limits the opportunity of the owner. It also specifies the time limit within which a shareholder and investors have to respond to the notice given by selling agents or shareholders, and this is usually for only 30 days. First refusal is also usually a right to buy on the same terms as agreed before. And through the right to first refusal clause in the agreement, new investors often dissuade from entering into the business. However, this clause does not stop another shareholder from selling the stock to a third party when a shareholder can’t afford to buy the selling share. In other words, this right only authorizes the shareholder to buy the shares first but does not provide any right to stop another when he himself cannot afford to buy those shares.

If the ROFR clause does not contain the conditions that the holder originally desires, he or she may choose not to purchase the property or real estate.

A settled contract price could damage: If you have a definite price point set out in the contract that ends up being cheaper than the current market value for the property, you could be leaving money on the table^[iv]. One more reason to consider not using the first refusal is that only the ROFR holder can execute and enjoy the right. The holder cannot pass this right to anyone without prior knowledge of the owner of the property; hence there is a restriction on this right.

First refusal tips

1. The ROFR clause should clearly define a time frame within which a party may execute its right of first refusal. The Seller should provide notice of an offer to the holder of ROFR stating the number of days within which the holder can execute the right.
2. ROFR provision must state which party should decide on the commercial terms of the offer.^[v]
3. The ROFR clause must exist in a valid contract. While the ROFR is given to one group, the other group must still obtain anything of interest, such as the amount of money.
4. The right to the first choice should answer what arises if the offer to purchase is not for cash, but instead other property, such an exchange for other property.
5. The Parties can determine whether or not they want the ROFR clause to be transferable to another party. The ROFR clause can transfer with the property, and in case the real owner sells the property to the new owner then, the new owner must have to provide the holder the right of first refusal^[vi].
6. The ROFR may have exceptions and specify the right does not apply to certain situations.
7. The contract should clearly specify when the ROFR clause is triggered. For example- it may arise in a situation when the owner wants to sell the property but not by offering security for the property to secure the loan.
8. It is advisable to define the real estate or property, which is subject to a right of first refusal.
9. The right of first refusal is no doubt is a contractual right that can create a huge impact on the business, but the language of the contract must be interpreted in the best manner to understand the ROFR clause, and it is best to consult an experienced attorney to understand the nuances of ROFR clause in a contract.

Conclusion and key takeaways

Right of first refusal clause grants parties certain rights under which they are given an option to purchase additional shares of the company or real estate before the same is offered to any new purchaser.  The first refusal provides additional control over the entry of a third party in the business, and this right is also known to be a preference.

For the first refusal to be more effective there should be a proper valid contract between the parties. There are a variety of contracts which may include a right of first refusal clauses such as general commercial agreement, lease, franchise agreement, and shareholder agreement. It is important to understand the benefits and drawbacks of having the ROFR clause in the contract. However, it is best to consult the attorney or lawyers to understand the terms of the ROFR clause in a contract or even in the shareholder agreement, to enjoy the benefits. 

References

^[i] https://www.deallawwire.com/2017/11/14/shareholders-agreements-right-of-first-refusal-versus-right-of-first-offer/

^[ii] https://legalvision.com.au/drafting-shareholders-agreement-first-right-r efusal/     

^[iii] https://www.upcounsel.com/right-of-first-refusal

^[iv] https://www.upcounsel.com/right-of-first-refusal

^[v] https://legalvision.com.au/the-right-of-first-refusal/

^[vi] https://www.nolo.com/legal-encyclopedia/what-is-the-right-of-first-refusal.html

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