What is the Right of First Refusal (ROFR): Things You Need to Know

The Right of First Refusal (ROFR) applies only to existing shares and grants current shareholders or the company the opportunity to purchase them before they are offered to an external buyer.

Typically, the ROFR clause is first outlined in the term sheet and later formalized in the shareholder agreement, company bylaws, or a separate agreement.

What is the Right of First Refusal (ROFR)?

The Right of First Refusal (ROFR) acts as a protective measure for existing shareholders, allowing them to retain control over ownership changes by preventing unwanted investors from gaining a stake in the company.

In venture capital deals, ROFR is typically granted to investors or the company as a protective measure against dilution and to help maintain influence.

How does the Right of First Refusal (ROFR) work?

When a shareholder receives an offer from an external buyer, they must present the terms of the third-party offer to all eligible ROFR holders, as required by the ROFR clause.

ROFR holders then have a specified period to decide if they want to step in and match the offer.

If multiple ROFR holders exist, they can participate on a pro-rata basis. If some ROFR holders choose not to participate, the remaining holders often have the right to acquire the unclaimed shares proportional to their ownership.

If the ROFR holders exercise their right, the shareholder must sell to them on the same terms as the third-party offer. If they decline, the shareholder is free to complete the sale with the external buyer.

Why do investors want the Right of First Refusal (ROFR)?

ROFR helps investors influence who joins the company’s cap table, ensuring it aligns with their strategic interests.

1. Increasing ownership‍

Investors often want to increase their holdings in high-growth companies. ROFR gives them the first opportunity to buy additional shares, allowing them to consolidate their position in the company.

2. Preserving ownership and control

By preventing unwanted third parties from acquiring shares, ROFR ensures that only approved investors or existing shareholders can increase their stakes.

‍3. Strategic exit planning‍

ROFR is often paired with co-sale (tag-along) rights, giving investors flexibility in liquidity events. If they exercise their ROFR, they can increase their stake. If they choose not to buy, co-sale rights allow them to sell their shares alongside the selling shareholder, ensuring they exit on the same terms.

Key terms of the Right of First Refusal (ROFR) Clause

A well-structured ROFR clause minimizes ambiguity, mitigates disputes, and establishes a clear, fair process for all parties.

1. Asset coverage

Clearly outline the assets covered by the ROFR, whether common shares, preferred shares, stock options, or other ownership interests. The clause should also specify any exclusions or special conditions to ensure it applies only to the intended transactions.

 2. Eligibility and thresholds

Clearly define who is entitled to the ROFR. Typically, it is granted to major investors who hold a minimum number of preferred shares or meet a specified ownership threshold.

3. Triggering events

Outline the conditions under which the ROFR is activated. This typically includes a shareholder deciding to sell their shares but can also cover:

• Sales of common shares vs preferred shares - Some agreements may trigger ROFR only for common shares, while others apply to both.
• New funding rounds - Certain investors may request that ROFR extend to new share issuances as well. 

4. Notification and response process

Define how and when the selling shareholder must notify ROFR holders. A standard process includes:

• A written notice to eligible ROFR holders, detailing the sale terms, including price, buyer identity, and conditions.
• A defined response period within which ROFR holders must decide whether to match the third-party offer.

5. Exercise terms and purchase amount

If a ROFR holder exercises their right, they are generally required to purchase the full allocation of shares under the same terms as the third-party offer. However, if multiple investors hold ROFR, they may participate on a pro-rata basis. If some investors decline, the remaining ROFR holders may have the option to acquire the unclaimed shares.

6. Order of priority

In agreements where both the company and major investors hold ROFR, the clause should specify the order of priority. If the company has the primary right to purchase the shares, investors receive a secondary right of refusal, often referred to as a "second refusal right."

7. Expiration 

Specify when the ROFR expires, whether after a predetermined number of years, upon a liquidity event, or if the holder declines to exercise their right once. 

8. Transferability

Specify whether the ROFR can be transferred to another party. In venture investing, these rights are generally non-transferable.

ROFR vs ROFO

When structuring shareholder agreements, both the Right of First Refusal (ROFR) and the Right of First Offer (ROFO) are used to regulate share sales. But they function differently and have distinct implications for the parties involved.

ROFR prioritizes existing investors by giving them the option to match any third-party offer before a sale can proceed.

While this helps investors maintain their stake and control ownership transitions, it can also discourage external buyers from negotiating, knowing their offer may simply be matched. This limitation can reduce liquidity for shareholders looking to sell.

ROFO, on the other hand, is a more seller-friendly alternative.

Instead of waiting for an external offer, the selling shareholder must first present their shares to ROFO holders, who then have a set period to make an offer. The seller can accept or reject it.

If rejected, they are free to negotiate with third parties but only on equal or better terms than what was offered by the ROFO holders.This strikes a balance between giving existing investors the chance to increase their stake while allowing the seller more flexibility to explore external buyers.

FAQs

1. What is the meaning of the Right of First Refusal (ROFR)?

The Right of First Refusal (ROFR) gives existing shareholders the first opportunity to buy shares from a selling shareholder before they are offered to an external buyer. This provision helps them expand their stake while regulating changes in company ownership.

2. How long does the Right of First Refusal (ROFR) last?

The time limit for exercising a Right of First Refusal (ROFR) is usually defined in the shareholders' agreement or the company's articles of association. The exact duration varies based on the terms negotiated between the parties.

3. How do I get the Right of First Refusal (ROFR)?

Investors often secure a Right of First Refusal (ROFR) as part of their investment terms, with the clause outlined in the term sheet and later formalized in shareholder agreements.

4. What are the Right of First Refusal (ROFR) and preemptive rights?

The Right of First Refusal (ROFR) and preemptive rights both help existing shareholders maintain their ownership but apply in different situations.

ROFR gives existing shareholders or the company the option to buy shares before they are sold to an external party. It applies when a shareholder decides to sell their shares and receives a third-party offer.

Preemptive rights, however, apply to newly issued shares rather than secondary sales. They allow existing shareholders to purchase new shares before they are offered to outside investors.