This article has been written by Nimisha, pursuing the Diploma in Law Firm Practice: Research, Drafting, Briefing and Client Management from LawSikho. This article has been edited by Tanmaya Sharma (Associate, Lawsikho) and Zigishu Singh (Associate, Lawsikho).

Introduction 

A right of first refusal requires the proprietor of a property to offer the property to the right holder on similar terms as those presented by that outsider before the proprietor can sell the property to an outsider. First purchase rights are commonly employed in a variety of contractual settings. They are found, among others, in a real estate sale and lease contracts, agreements among shareholders of a closely-held company, joint ventures, franchise agreements, and management agreements. When a right of first refusal is not included in the agreement, the seller can sell the subject property to a third-party buyer. In a right of first refusal, a third-party investor has to decide whether to enter into an agreement that is subject to a right of first refusal.

Difference between ROFR(Right To First Refusal) and ROFO (Right To First Offer) 

ROFR varies from a Right of First Offer (ROFO). ROFO, otherwise called a Right of First Negotiation, merely obliges the owner to undergo exclusive good faith negotiations with the rights holder before negotiating with other parties. A ROFR is a choice to enter an exchange on careful exchange terms. A ROFO is merely an agreement to negotiate. 

Right to the first refusal of a shareholder

A ROFR clause in the term sheet gives investors the choice to buy shares from the company before the shares are offered to an outside party. If they exercise this right, the issue price must be the price offered to the third party. 

Some term sheets first give the option to the company, then to the investor, while others simply give the option to the investor. If there are multiple venture capital investors, the ROFR provision typically specifies that each has the option to purchase a pro-rata portion of the shares being sold.

Relevance of investor’s right of first refusal clause

This clause protects the interest of investors and is very important. In case the founders intend to exit the company due to some event, then investors should have the right to first purchase the stake of founders. The founders cannot exit before the lock-in period if there is a clause to that effect in the term sheet. 

This is how a Right to refusal clause may look like in a term sheet, 

“If any of the company’s shareholders other than the investor proposes to transfer any of their company shares to a third party, then the investor will have a right of first refusal to purchase those shares on the same terms as the proposed transferee. “

Role of right to the first refusal in start-ups equity

In events such as the right to enter a joint venture or distribution arrangement Investors generally negotiate for ROFR when the founders or other investors are willing to sell their shares as they have to match the price at which a third party is willing to purchase such shares of founders or existing investors. One more reason why investors are inclined towards ROFR right is that they get to know what is the price of the shares in the market and this makes their job easy as to whether they want to increase their stake in the company or not. This right gives the right holder the option to get more involved at a later point. Such a right, however, is time-bound, and therefore after the expiry of the period, the seller is free to pursue other buyers.

Note for startups – A ROFR contains a longer and more extensive method to liquidate shares of a company. A startup should try to provide the investor with a ROFO rather than a ROFR.

ROFR (Right of first refusal) versus ROFO (Right of first offer) 

• When negotiating a shareholder agreement one concern that impacts the shareholders’ decision is controlling their share ratio. ROFR works as a tool for them to maintain control of their share percentage in the company. 
• ROFR- It provides the existing shareholders with the right to accept or refuse to buy shares of a selling shareholder. ROFO – A similar known mechanism in a shareholders agreement that provides non-selling shareholders with the right to be offered the shares before any external solicitation takes place. 
• The point to be noted here is that ROFR provides the non-selling shareholders with the right of first refusal to offer from selling shareholders after the selling shareholders has received a third party offer for shares. 
• On the other hand, ROFO provides the non-selling shareholders with the right to first make an offer to the selling shareholders before the shares are offered to the third party. 
• The price of shares gained by the Right to first refusal may be influenced by the third party’s offer to buy the shares. 

• A ROFO allows the selling shareholders to make an offer to the non-selling shareholders instead of approaching the third party. 
• In reality, the third party is reluctant to negotiate and buy shares when they are subject to a ROFR. This is because they’re uncertain about future investment plans in the company if they buy the shares. 
• This causes a reduction in prices offered by the third party and the selling shareholders are at risk of selling them at a lower price. 
• On the other hand, the ROFO mechanism often favours the selling shareholders as there’s no obligation to accept the offer to buy from the non-selling shareholders. 

Simply put, 

• When a stockholder wants to or prefers to sell some stock, they have to present an offer to the inside venture capitalists if they have a right to first refusal. 
• The venture capitalists, mostly in good companies, always want more ownership as professional investors. 
• If the stock sellers sell their shares to outsiders, there could be information rights transferred to them. And all the actual financial results of those companies may get out, which will result in losing control of the company. 
• If the insider venture capitalists refuse to buy the shares, then the selling shareholders can market them to get some liquidity. 

Conclusion

The author has mentioned the role, advantages, and disadvantages to include ROFR in your shareholders’ agreement. Although all this information is not exhaustive and needs to be studied in different circumstances. While drafting the ROFR clause one must do an analysis of the advantages and disadvantages of this particular clause. 

References

• https://ereadcost.eu/right-of-first-refusal-clause-in-shareholders-agreement/ 
• https://www.berkeleylegal.com.ng/2018/05/18/shareholders-agreement-key-provisions-and-their-relevance/
• https://www.nolo.com/legal-encyclopedia/what-is-the-right-of-first-refusal.html 
• https://www.netlawman.co.uk/ia/controlling-entry 

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