The Right of First Refusal (ROFR) entitles its holder to have a first say on a share sale. For example a company may have a Right of First Refusal on any sale of its shares. If one of its shareholders found a buyer for her shares, then the company has the right to buy those shares at the conditions negotiated with that original buyer.
It provides the company with a way to control its cap table and reduce private transaction in its shares. Additionally it provides optionality to buy back shares and/or give its investors the opportunity to buy additional shares between fund raises.
The ROFR might be grouped with Tag Along rights under the “Stock Restrictions” section. This depends a bit on the common practice in your startup eco-system. The nature of the clause is however not affected by such titles of course.
Standard Startup Right of First Refusal
A typical Right of First Refusal is a right to the Company and/or to the Investors in relation to shareholder stock sales. There maybe a threshold of a few percent of share ownership per selling shareholder for the ROFR to apply. Additionally, the ROFR may also include all share sales/issuances by the company itself. E.g. if any round is raised, the existing investors may have the right to participate pro-rata to their shareholding. This gives them a way to not get diluted in upcoming fund raises.
Variations to the Right of First Refusal
As with any right drafted by a startup investor,there is a lot of flexibility in how to draft the ROFR. The following section covers the main variations you could consider. As always, take it with caution. You need to ask your lawyer which variations are legal in your specific jurisdiction, though most of them should be. Also you don’t want to make these terms to complicated. Usually the next round’s investors will raise their eye brows and revert totally uncommon terms to something more customary anyways. And it doesn’t make sense to grant such rights to parties who don’t have the financial capabilities to execute them either. After-all you don’t want to waste a lot of time negotiating meaningless clauses.
One area of variation in ROFR terms is the threshold beyond which share sales trigger an ROFR. This could be an ownership percentage of total capitalization per shareholder, or it could be grouped across the company. E.g. one could say only shareholders holding at least 2% of all shares fall under the ROFR selling restrictions. That has the advantage of making small minority sales less complicated. The flip-side is that most angels will eventually fall under 2%. So this exception would still be a gateway for unwanted investors to join your cap table (think of competitors).
Secondly, a company-wide threshold could state that any sale above X% or a sale for the majority of stock ownership is triggering the ROFR. Here one needs to think through cap table dynamics again. For example, if the investors and even the founders have fragmented holdings this might not be a very effective threshold. Also it could seriously stifle majority exits (selling 51%+ of the company), if the original investors have the right to participate in such a transaction. Just administratively, the new buyer who wants control of the company will have a hard time achieving it. The ROFR offer process is just too fluid and the outcome can’t be guaranteed upfront.
Who can hold this Right?
Again typically the company will hold a ROFR. This allows it to control the cap table by buying back shares and reducing individual sales of shares. But of course the ROFR can also be granted to individual shareholders or groups. So investors could have a separate ROFR to control the cap table for situations where the company doesn’t have the funds to execute their right. Or Founders could negotiate for a ROFR to ensure they don’t have to work with unwanted investors. This however only makes sense, if they have the money to execute it.
Provided that multiple groups have an ROFR one needs to determine an application order. For example the ROFR on a share sale could first go to the company, then to founders and then to investors.
Purpose of the Right of First Refusal
Reduction of Buyer Interest
Firstly, having a ROFR in place certainly reduces buyer interest for any share sale. Imagine being a potential buyer of a privately held startup. You now have to do the full evaluation of that business, negotiate with seller, make a formal offer and then the seller has to go back to the Company and offer “your deal” to the company or its shareholders. Even if the seller is your buddy from college and you don’t end up doing a full professional due diligence, you still are going to think twice if you are even wasting an afternoon putting together an offer. Of course, one has to take this with a grain of salt. The existence of an ROFR usually isn’t discussed in the first pitch meeting(s). Also which startup would actually want to (or is financially capable) of executing it? Thus it might not be such an insurmountable deterrent for a sale as it is often made out to be. But as always it depends.
The reason for wanting to reduce buyer interest of such transactions is that the same buyer might actually become an investor in the next fund raise. Fund raises bring money to the company, while private share sales only benefits existing shareholders. The latter might signal to the market that some existing shareholders are seeking to “get out” of the cap table.
Control over Cap Table
Secondly the ROFR allows specific control over who might join the cap table. This is of interest because even a few percent of voting power can make a difference. Think of veto thresholds. A small sale of shares can be a significant power change. This is especially true, if there is one major investor who just needs a few more percent to control the vetoes.
Alternatively think of a competitor buying a small stake at a high value from one of your angels. This could mean your competitor has the same information rights as all your other investors.
Sample Right of First Refusal
Below is a sample ROFR as it could be used in a term sheet. As always get yourself a lawyer for your own term sheet, but definitely for your binding deal agreements. Also the full text for the binding deal agreements will be more detailed.
The Investor Group reserves the first right to participate in future equity fundraising rounds (at the same valuation as such future fundraising rounds) up to an amount equal to its shareholding in the Company prior to such raise so as to maintain its shareholding in the Company at the same percentage subsequent to such a raise.
This ROFR is a relatively simple one. It allows the investor group to pariticipate in any future fund raise at the same price of the new investors. There is no specific threshold and it excludes share private sales by individual shareholders. One can argue this part is missing, but then again how often will that actually be an issue.
On the flip side, having a participation right in future fund raises does have value to investors. Small angel investor with the capacity to only buy shares for a couple ten thousand dollars will likely not be allowed into a VC round otherwise.
Downside of the Right of First Refusal
The biggest downside with the ROFR is that it can significantly reduce liquidity of your startup’s shares. Yes its a protection against having a competitor on your cap table, but how likely is that actually. Just think of the cost in relation to the advantage to your competitors. In contrast, it really might reduce your shareholders ability to sell shares down the road. And not every startup is going to IPO or have an exit in some reasonable time frame, if at all.
Also, how likely is that a VC bothers to waste time to buy small stakes from your angel investors. If they would be in the market for a large stake, they would prefer to invest the money to grow the business. Well, and such a buyer would also be not too keen to just buy the majority owners shares. cause those will be the founders’ shares. Usually such a buyer wants to retain the founders and/or buy the entire company. Furthermore that last scenario should be protected from the investors side with a Tag Along, so they can join a partial exit as opposed to necessarily blocking a deal with an ROFR.
Alternatives to the Right of First Refusal
The purpose of controlling the cap table can also be achieved by restricting any share sales by individuals. This can be done for a certain period, or with an investor veto, or with a board vote. The difference is that a potential buyer then doesn’t have to worry so much about their “deal” being taken away. Especially with a board vote, one can relatively easily gage whether the board will welcome the new shareholder or block him. In contrast the ROFR would probably be executed at the last minute for strategic reasons. If one would know a ROFR would be executed (especially by investors) the seller would start a negotiation with them instead of going all the way to send out an ROFR offer letter.
Despite all the listed drawbacks of ROFRs such as its chilling effect on share sales, they are quite common. They provide an additional tool to manage the cap table. This can be useful as voting powers can shift dramatically across funding rounds. So while your fund’s board seat might get lost over time, the ROFR might still provide another tool to exercise a different level of control over share sales. Just keep simplicity in mind drafting these clauses. You don’t want your term sheet negotiation be stuck for one week over such technicalities which may never have an impact.
This guide is not intended to and does not constitute legal or tax advice, recommendations, mediation or counseling under any circumstance. This guide and your use thereof does not create an attorney-client relationship with Startupvaluationschool.com or Ed.Pres Limited. The guide solely represents the thoughts of the author and is neither endorsed by nor does it necessarily reflect Ed.Pres Limited’s belief. Ed.Pres Limited does not warrant or guarantee the accurateness, completeness, adequacy or currency of the information in the guide. You should seek the advice of a competent attorney or accountant licensed to practice in your jurisdiction for advice on your particular problem.
Table of Contents