Right of First Refusal: Whenever a shareholder desires to sell his shares, he is required to provide a notice of an offer from a third party, who wishes to buy his stake. The required notice must be in writing to all the shareholders of the company. Subsequently, all the other shareholders then have the first opportunity to purchase those shares at the same terms as that of the offer. Either the remaining shareholders can purchase the shares or the company can buy back the shares. If none of these options go through, only then the shareholder will proceed with the third party’s offer.
Why is ROFR important?
This clause provides security, protection and prioritizes the interests of the company first. This clause is particularly important when a majority shareholder wishes to leave the company. This clause ensures that the control of the company stays intact with the existing shareholders.
It provides a fast and hassle-free option to the shareholder desirous of selling their stake in the company, and exit after taking their investment and profit. In the case of startup funding, incorporation of the Right of First Refusal clause blocks inducement from an external investor from investment. In the event of a share sale, the same deal is offered to the current existing shareholder to prevent their stock from being depleted. It allows the co-founder of the startup to have more control over the composition of the company. This is crucial especially when shares are attached with substantial voting rights. Giving the existing shareholders the option of ROFR helps retain the stake as well the startup’s vision.
Lastly, this right strikes a balance of power between the minority and the majority shareholders. In the event of the share sale by a majority stakeholder, the interest of the minority is not curtailed.
What should the “Right to First Refusal” clause include?
There are a few terms that must be kept in mind while drafting this clause. These are –
- Time Frame -the clause should mention the time frame within which the other shareholders can exercise this right of first refusal. Without any time frame, this clause will be rendered open-ended. A time period specifies the date for the shareholders to respond to the notice of intention to sell; it is generally a 30-day period. Lack of time period can lead to ambiguity and cause problems while dealing with a third party.
- Notice period – this term provides how the selling shareholder must provide with the intention to sell shares notice to other shareholders.
- Terms of sale – the clause must specify the different circumstances of the sale. For example – what happens if every shareholder wants to purchase a portion of the shares? What happens if only some shareholders are interested?
One answer to this problem can be that the selling shareholder is required to sell its shares on a pro-rata basis, based on the shareholder’s proportionate shareholding. Apart from this, other required mandates can be drafted in this clause to tackle each situation.
- Procedure for sale and transfer – once the remaining shareholders have agreed to buy the shares, the selling shareholder must transfer them. If for any reason the selling shareholder refuses or does not transfer the shares when required, the company can act as the attorney of the selling shareholder and undertake the transfer on agreed terms. This clause must be set out for all these provisions.
So far, we have discussed how significant this clause is to every company while drafting the shareholder’s agreement. For an effective ROFR, the company must ensure its proper execution and application. The shareholders must understand the terms and conditions of this clause before agreeing to it. The company should draft this clause in a manner that not only provides protection but also confers a maximum benefit to it.