A right of first refusal (abbreviated to ROFR and also known as a right of pre-emption) is an optional right that company owners can give to each other in a shareholders agreement.
The clause allows existing shareholders to buy the shares of an owner who is selling before any outsider can do so. The price paid is usually the price that the external buyer has agreed to pay.
There is no standard wording. The clause could be very simple in how it works, or have many conditions attached that vary the price or the amount of shares that any existing shareholder can buy. There might also be other clauses in the shareholder agreement that limit the effect of the ROFR clause (such as those that limit voting power on certain matters).
The offer price
The inclusion of the clause has an interesting implication on the price at which shares are sold.
If we assume that existing owners have better information about the true value of the company (and future prospects), to be allowed to buy, any outsider will have to offer more money than any insider would pay.
If the outsider offers a lower price than the existing owners value the company at, then the existing owners (provided they have the money to do so) are likely to buy the shares themselves.
In other words, with a ROFR clause, effectively, outsiders pay a premium price to come into the company.
And unlike a subscription for new shares, it is the outgoing shareholder who benefits, not the remaining owners or the company.
Why use a ROFR clause?
ROFR is not a right that shareholders have by default under the Companies Act. It must be agreed explicitly in the shareholders agreement. The reasons why they might want to do so are:
Controlling who can become a shareholder
ROFR gives existing owners the opportunity to prevent outsiders from buying shares and therefore exerting control over the company.
The clause can’t prevent sale to an external third party, but it does give the opportunity to the existing shareholders to block the entry of a new owner.
Maintain the proportional ownership of the company
Many right of first refusal clauses are worded so that all owners have the right to buy in proportion with their current shareholding. For example, if company shares are held 50% : 25% : 25% by three founders and one of the owners of 25% wishes to sell completely, then the owner of 50% of the shares has the right to buy up to two thirds (50/75) of the shares being sold.
This allows relative control of the company to remain the same, which may be important for a shareholder with a small majority or a minority who doesn’t want a majority (for example, one who already holds 74% of the shares) to gain additional power.
Discouraging external investors from bidding
A right of first refusal is a right to buy on the same terms. In order to do so, those terms must have already been agreed, and to arrive at that point, most external investors will have carried out a lot of due diligence on the company and spent time negotiating the terms.
If a potential external buyer knows in advance that he will have to carry out a lot of work assessing the value of the company but that there is a high chance he will never be allowed to buy, he might simply walk away as soon as he learns of the existence of the ROFR clause.
A right of first refusal clause can be such a sufficient disincentive to an external buyer, that the existence of one often makes it more attractive to founders to sell the company together in agreement rather than selling individually. Including a ROFR clause in the shareholders agreement can motivate founders to pursue the same strategic goals so as to maximise the price of the company when they do sell.
Because it is such a discouragement to incoming shareholders, including one in the shareholder agreement acts as a disincentive to founders who might want to sell. It will be hard to find anyone who is willing to buy the shares, and risk invest time and money in the due diligence process if the outcome is likely to be that he is blocked from buying by the existing owners. With a ROFR clause in place, all shareholders – particularly minority ones – are likely to be carried along with the decisions of the others.
Should you include a ROFR in your shareholders agreement?
Right of first refusal clauses are fairly unusual in shareholder agreements that founders would set up. Most solicitors drawing a document from scratch for you would not assume that you would need one, and the vast majority of shareholder agreement templates do not include them. They tend to be an instrument later on in the company lifecycle, rather than at the start.
The reason is that although a ROFR clause has advantages it can also disadvantage you by limiting your options when you sell. You might be selling because you want out, but in an early stage company, there might be other reasons you are selling – you might need to raise further equity finance or cash out of your investment for personal reasons.
If you are considering using one, our advice is to find sample wording within a shareholder agreement template and review whether what it does is really what you want. We wouldn’t advise simply ordering the inclusion of the clause from your solicitor straight out.