Rights of First Refusal: What They Are and Why Your Business Wants Them
Imagine that you own a business with two other people. Splitting ownership between the three of you has been a nice way to split costs, risks, and responsibilities. However, there comes a point when one person wants to sell their ownership stake and get out of the business.
This kind of thing happens all the time. People retire. They decide they want to do something else. They run into financial problems, and selling their stake seems like a great way to get a nice chunk of money.
Ideally, the three of you would work together to figure out what happens to that person’s ownership stake. Perhaps you and the other remaining owner want to buy the departing owner out, split evenly. Or you agree to vet potential people as a group to take over the departing owner’s percentage. The point is, you are given a say in who owns that last third of your business.
Not always, though. Sometimes, when a person wants to sell, they decide to go their own way – even if the rest of the owners disagree. You can imagine how this might put you and the remaining owner in an uncomfortable situation. What if the new owner has a bunch of bad ideas? Or you just genuinely don’t like working with them? There are all kinds of ways that this kind of situation can go south.
That’s where Rights of First Refusal (ROFR) come into play. Essentially, they provide the continuing owners of the business with the ability to say no to a transfer of shares that they do not agree with – or to the transfer of certain kinds of rights associated with those shares.
How do these kinds of clauses in governing documents work and what kinds of problems can arise?
Make Sure Your Business Can Refuse a Transfer of Shares
If owners can transfer their shares of ownership willy-nilly, your business will pay the price. The best way to protect yourself is by drafting a strong, specific ownership agreement.
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Hi, welcome back to another dose of Bite-sized Bits of Knowledge, where we give you meaningful information in a short amount of time. So, up to this point, we’ve covered a lot of material. We’ve talked about companies. Legal, nonlegal insight and recommendations. We’ve talked about formation – different kinds of entities. We started talking about the operating agreements and governing documents of other types of entities and what goes in them.
So today we’re going to continue with that, and we’re going to talk about something you’re going to see in a lot of agreements. And that’s called a right of first refusal. Right of first refusal sometimes has an abbreviation of ROFR. You’ll see them in concept in a lot of different kinds of documents, like the operating agreement for an LLC, shareholders agreement of a corporation, limited partnership agreement of a limited partnership, partnership agreement for a general partnership, and so forth.
They are similar in concept. They differ in terms and substance. The devil is truly in the details. You really need to be careful about that.
So here’s what it is. Consider a situation where you’ve started a business, you’ve worked your butt off, you put in all of your time, money, energy, effort, and you’ve built something special. And then you have a partner. So you have two partners, and your partner says one day, “Hey, I got an offer to sell my one-third interest to my neighbor. He’s just looking for a good investment and he liked what we’re doing. And I showed him some of the numbers” – which is an issue in itself. “And this person wants to buy it and I’m selling. So guys, it’s been great. And I’ll be closing probably in a couple of months. And I’m out and he’s in and good luck.”
So what happens in that situation is you have a third party coming into the picture to be a partner with you and your partners. You don’t know the person, you don’t know if they’re qualified, you don’t know if you like them. There’s so many reasons why that is a terrible idea.
And so to prevent the alienation of shares – the transfer of shares without permission of the partners or without approval of the management board – one of the ways to do this is called a right of first refusal. And that basically translates to this:
In that same situation, the neighbor says, “Hey, I want to buy your shares for X dollars on Y terms.” That offer has to then be communicated and extended to the partners. The same offer, the same price, same terms, has to be given to the partners to say, “Okay, we have the right to exercise that offer and accept that offer first.”
And there’s a whole process for how this works. The idea being that you want to give the partners the right to take advantage of that opportunity. To keep it in the family, so to speak. To keep this other person out and keep it all in the house.
And there’s a whole sequence of steps that has to happen. And there’s time limits. A good one is time limits to make it work properly. And if everything goes well, then the shares are acquired by the partners in some fashion and the neighbor’s out and your old partner is out, and everybody that was already existing in the company remains.
Usually, these provisions have language that says, “If the partners don’t timely accept, then the transaction can continue.” Which it should. But usually good documents will have a lot of restrictions so that if anything goes wrong along the way, it starts the process over to give the partners, yet again, another bite at the apple and to make it harder to get rid of your shares to a third party that would be undesirable for your existing partners.
So that’s the idea of the right of first refusal. It’s just a concept that you’ll find in documents frequently. There’s other ways to approach it. We’re going to talk about that in a moment when we talk about different types of transfers. So that’s right of first refusals.
I appreciate you stopping by. Thanks for tuning in. Don’t forget to download our free materials linked below relating to our business planning stress test and our formation chart and other helpful things you’ll find along the way.
Thanks for tuning in and stay tuned for more.
Rights of First Refusal is a specific way to do this that allows the rights holder – i.e. the business or the continuing owners – to match the offer of someone attempting to purchase shares as a way of ensuring those shares stay with the business rather than going to someone that hasn’t been agreed upon by all of the owners.
It is possible to customize these types of clauses for your needs. Some of the most common customizations include allowing the purchase to be made by a third party the buyer nominates or clarifying exactly how long the rights holder’s right of first refusal remains valid.
Right of First Refusal Vs. Right of First Offer: Know the Difference
Another common contractual agreement is the right of first offer (ROFO). While the ROFR is focused on empowering the rights holder with the ability to match or decline an offer that the seller has already received, ROFO gives the rights holder the opportunity to bid on shares before they are offered to anyone else.
While there are benefits and drawbacks to both types of agreements, ROFRs are far better at protecting your business. Some of the positives of ROFRs include:
- Acting as a form of insurance to secure purchasing rights.
- Offering priority in the transaction process.
- Providing a competitive advantage over other potential buyers.
This is not to say that ROFOs are without benefits. Among other things, they:
- Grant rights holders the first opportunity to bid on an asset.
- Avoid competition during initial negotiations.
ROFOs may also include conditions that limit the sale price or what terms are acceptable. For instance, ROFO agreements sometimes require the seller to keep the asset’s sale price within a specific range if it’s offered to third parties or listed on the open market. Conversely, ROFR agreements prioritize the buyer but can make the asset less appealing to other potential purchasers.
That being said, in general ROFRs tend to favor buyers by providing assurance and priority, while ROFOs typically benefit sellers by allowing them to initiate negotiations on their terms.
Understanding these nuances can be incredibly complicated. If you want to make sure you set your business up for success right from the start, let us help you put the strongest legal framework in place. Reach out now!
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Business planning stress test
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Originally published 03/17/2022. Updated 01/22/2025.
Author:
Barry E. Haimo, Esq.
Haimo Law
Strategic Planning With Purpose®
Email: barry@haimolaw.com
YouTube: http://www.youtube.com/user/haimolawtv
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