The Right of First Refusal can play an important role during secondary transactions in the private market. For buyers and sellers of secondary shares alike, understanding the nuances of Right of First Refusal can be important as it can impact the shares bought and sold. In this blog post, learn more about how right of first refusal impacts investors from both a buyer’s and seller’s perspectives, its importance, some key considerations for investors, and the typical timeline of a share sale involving ROFR.
What is a Right of First Refusal?
The Right of First Refusal (ROFR) is a contractual agreement that gives the issuer (the company that issues the shares for sale) the opportunity to purchase back the shares before they are offered to outside buyers. In private companies, this right is typically outlined in the company’s operating agreement or shareholder agreement. When a shareholder decides to sell their shares and there is a ROFR provision, they must first offer them to the issuer, who have the option to buy the shares at the same price and terms offered as the third-party buyer.
Why Does ROFR Matter?
ROFR can be an important mechanism for the private company to maintain control. It can provide a company with a chance to preserve their ownership stakes and may prevent unwanted third-party investors from entering the company, which could disrupt existing relationships or strategic goals. For buyers, understanding ROFR is also important, as it can affect their ability to acquire shares.
Seller’s Perspective: Navigating ROFR
When considering a sale of shares, a seller should keep several factors in mind regarding the ROFR:
Understanding the ROFR Terms
Sellers must first understand the terms of the ROFR clause in their shareholder agreement. The specifics of the ROFR can vary, including how long existing shareholders have to exercise their rights and the procedures they must follow.
Potential Delays
If existing shareholders decide to exercise their ROFR, the seller may face delays in completing the sale. This can impact liquidity, especially if the seller is looking to access funds quickly.
Impact on Market Value
A ROFR can influence a seller’s expected sale price. If existing shareholders are likely to exercise their rights, potential buyers may factor this into their offers, potentially driving down the price.
Buyer’s Perspective: Navigating ROFR
From a buyer’s viewpoint, the ROFR can also present both opportunities and challenges:
Access to Shares
Buyers will ideally be aware of the ROFR when pursuing shares. If existing shareholders exercise their rights, the buyer may lose the opportunity to acquire the desired shares.
Response Timelines
Buyers should consider how the presence of a ROFR might affect the timing of acquiring the shares. There is a set period for an issuer to respond to a ROFR, and the buyer might be waiting for the ROFR to be exercised or for the ROFR period to expire. Additionally, If a ROFR is exercised, an investor may explore the possibility of acquiring other shares at similar pricing, but that could take a while, if similar shares are even found.
Key Considerations for Investors
Both buyers and sellers may consider several key factors when dealing with ROFR in secondary transactions:
Legal Framework
Becoming familiar with the legal aspects of ROFR agreements can be important. Investors may want to consult legal experts to ensure compliance with regulations and to understand their rights and obligations.
Market Conditions
The current market environment can influence the desirability and execution of ROFR. Investors should assess the demand for shares and the potential impact of external economic factors.
Communication with Stakeholders
Transparency and communication between buyers, sellers, and existing shareholders can help facilitate smoother transactions. Establishing clear channels for dialogue can help mitigate misunderstandings and foster trust.
How Does ROFR Work?
Understanding the timeline of a share sale involving ROFR may help clarify the process from initiation to closure:
1. Transfer Notice of ROFR
The broker-dealer facilitating the share sale notifies the company of the intent to transfer shares and discloses the terms of the transfer including the name of the proposed transferee, the number of shares, the price, or other considerations.
2. ROFR Period
The issuer typically has a specified period (often 30 days and outlined in the ROFR agreement) to decide whether to exercise their rights.
3. Decision Phase
The company assesses whether they want to exercise their ROFR. It has a few different options during the phase. The company can let the ROFR expire after the 30 days or waive the ROFR early before the end of the 30 days. It could also choose to exercise its ROFR at any time within the 30 days. Once a decision has been made, it is communicated to the broker-dealer facilitating the transaction, or the period lapses and the ROFR expires.
4. Completion of Sale:
If the ROFR is not exercised, the seller can proceed with the sale to the third-party buyer. If exercised, the seller completes the sale to the existing shareholder(s) instead.
Scenarios for Buyers
There are a few scenarios that occur for the buyer whether or not the ROFR is exercised and what happens to the transaction.
Scenario 1: ROFR Not Exercised
In this scenario, the issuer decides not to exercise their ROFR. The seller can then proceed with the sale to the third-party buyer. The timeline is relatively straightforward, allowing for a smooth transition of ownership. This scenario can be favorable for the seller as it provides them with a liquidity opportunity.
Scenario 2: ROFR Exercised – New Shares Found
In this case, the issuer exercises its ROFR, and the seller completes the sale to the company. Then, the broker-dealer facilitating the transaction may attempt to find new shares at a similar price and terms as the original transaction to then sell to the buyer. The process of finding new shares can be lengthy, and once new shares are found, the notice process starts over. It is possible that the issuer decides to ROFR the new shares as well, and then the process of finding new shares starts over. This can draw out the entire process and make it take months longer than originally intended.
If new shares are found at a materially increased price, the investor(s) will be informed and can confirm their intent to still purchase at the new price.
Scenario 3: ROFR Exercised – No New Shares Found
The final scenario is that the company exercises its ROFR, and new shares are not found at the same or similar terms. This can happen after the initial ROFR, or if the rights are continuously exercised by the company until new shares aren’t found. If new shares cannot be found, then the funds are returned to investors.
Final Thoughts
The ROFR can be an important component of private market secondary transactions, influencing the dynamics between buyers and sellers. By understanding the ROFR timeline and the various ROFR scenarios, investors can make informed decisions about buying and selling private shares in the secondary market.
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Want to learn more about startup investing? Check out the following MicroVentures blogs to learn more:
- The Pros and Cons of Investing in Private Companies
- Private Equity vs Venture Capital
- Navigating Deal Sourcing: How to Select Investment Opportunities
- Unlocking New Opportunities: Investing in Alternatives
- The Early Advantage: Investing Pre-IPO
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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.
