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Right of First Refusal

Tyke Editorial Team by Tyke Editorial Team
September 5, 2022
Reading Time: 8 mins read
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Have you ever wondered why Venture Capitalists always negotiate the Right of First Refusal in the stock purchase agreement? What is the Right of First Refusal, and why is it significant for VCs? Why are the VCs given the Right of First Refusal?

Well, to answer all these questions, it is important to understand the meaning and significance of the Right of First Refusal for start-ups and Venture Capitalists. They enter into business deals with start-up companies.

Right of First Refusal

Right of first refusal is a contractual agreement that allows one party to buy a property before it is offered to the public. An investor can use it to invest in properties for future development.

The right of first refusal can be granted by the seller or by the buyer. In most cases, it is granted by the seller and usually involves some sort of monetary penalty if not accepted. In the case of companies, the Right of First Refusal is provided to the investors, especially the VCs, who are the company’s initial investors.

Right of First Refusal is included in the stock purchase agreement signed by the venture capitalists when they raise funds for the Start-ups.

VCs are always interested in getting more stake in the ownership of the start-ups they have invested in. They are the investors who would always want to make money and buy more shares to increase their stake in the companies, especially those they think are the good ones.

When these start-ups opt for secondary issues to raise more funds, the company issues stocks in the market as a part of a down round. Down rounds are the subsequent issue of stock that the companies issue in the market to get additional funding. During the down rounds, the founders give first opportunities to the existing investors, who, in most cases, are the Venture Capitalists. When VCs agree to purchase those stocks, they can maintain the proportionate shareholding rights as well as get a higher number of shares.

On the contrary, when the VCs and other investors cannot purchase these shares for specific reasons, they can practice the Right of First Refusal (RoFR), which means they can refuse to buy those shares.

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What is the Right of First Refusal Clause in Start-Ups?

The Right of First Refusal Clause is a clause in the contract between the investor and the start-up which states that if an investor wants to withdraw from the investment, it has to offer it first to other investors.

Start-up businesses may need several rounds of funding in the initial period. There is a possibility the company may opt for the subsequent rounds of funding, for which it has to issue additional shares in the market. However, before issuing the shares to the new investors in the market, the start-ups provide the same offer to the existing shareholders at the same price.

RoFR is also known as preemptive rights, anti-dilution, and subscription rights as they are the clauses that provide the existing shareholders who are given preference to purchase the shares they issue in the subsequent rounds.

What is the Right of First Refusal Clause in Start-Ups

Venture Capital Deals Vs. Right Of First Refusal

In the early days of a start-up, venture capitalists may be tempted to offer a large sum of money for an equity stake in the company. However, there are many drawbacks to this type of deal that have made it less popular over the years. One of these drawbacks is that once a venture capitalist becomes a shareholder, they have priority over any other investor who might want to buy shares.

Right of first refusal is when an investor has the right to buy shares before offering them to other investors. This gives them leverage in negotiating prices and other terms with founders. But it also means that they cannot sell their shares as easily as they could if they had invested in a venture capital deal because they cannot sell their shares to third parties.

The Right of First Refusal (RoFR) is present in the stock purchase agreement, which the VCs duly sign. In case they are not signed, the VCs would always emphasize you include the Right of First Refusal in the stock purchase agreement that allows them to get preference to purchase the shares sold by the investors. These stocks can be equity issues, preference shares, or any other, providing the VCs an opportunity to buy them at the offered price.

Thus, this is one of the clauses which is always insisted on by the Venture Capitalists to be put in the stock purchase agreement.

The Investor’s Perspective On A Right Of First Refusal Venture Capital Deal

A right of first refusal is a clause in a shareholders’ agreement that gives the company’s previous investors the right to buy shares before they are offered to other parties.

The investor’s perspective on a right of first refusal venture capital deal is that it gives them an advantage in getting their money back. It also prevents other investors from taking control of the company or investing in the company without their consent.

How will the Right of First Refusal Clause function?

Right of First Refusal (RoFR) Contracts are just like options contracts because under these contracts, the holders have the right to enter into a transaction, but they are not obligated to do so. The contracts further provide the opportunity to establish the agreement on the assets before others get the chance to enter into the contract.

When the companies issue additional shares to get additional funding, they give the first preference to the existing shareholders to buy the shares at the proposed rate. In case the shareholders refuse to buy these shares under the RoFR clause, the same shares are issued to the new shareholders.

The RoFR clause plays a significant role not only in start-up companies but in the case of mergers, acquisitions, and amalgamation. One of the well-known examples is the multi-billion deal between Vedanta Resources and Cairn India, where Carin Energy needed consent to sell a $9.6 billion deal with Vedanta Resources in 2010. The company wanted to sell its controlling stake in Cairn India, but ONGC, who had the Right of First Refusal, ruled out Vedanta Resources’s offer and entered the said deal with Cairn India.

The RoFR clause not only provides the non-disposing investors with dispensation to accept or reject the offer of purchasing the stocks from the founders.

Legality and Relevance of RoFR Clause

Any investment needs certain assurance against his investment in any company. RoFR is one such assurance provided by the founders to the investors, conditionally limiting the company’s promoters from selling the equity to any third party. Under the RoFR clause, the issuer, founder, or promoter binds themselves to offer the shareholders the first right to accept or reject the purchase of the shares. They are the preemptive rights that provide the existing investors the right to refuse to purchase the offered equity.

The legal status of the RoFR clause was questioned primarily in the case between Western Maharashtra Development Corporation and the company Bajaj Auto where the court, under Section 111A of the Companies Act 1956, held that any transfer will be restricted among the said parties.

Later, following the subsequent appeals, the court decided under Section 58 of the Companies Act 2013, that the public companies are empowered to enter into the agreement with two or more parties when it is concerned with the subsequent transfer of shares who can include the section of RoFR., giving legal status to the public holding companies to practice and include the RoFR clause along with the private firms.

Thus, RoFR stands valid and completely lawful when it was examined on the principles of the Indian Contract Act and has been drafted accordingly.

What are some important considerations for a New Startup Owner to keep in mind when designing the Right of First Refusal Clause?

The Right of First Refusal Clause is a clause that protects the purchaser from being outbid by another buyer. It helps the existing investor retain the share value and the company’s equity rights.

There are three important considerations for a New Startup Owner to keep in mind when designing a Right of First Refusal Clause:

  • The time period for which the right applies
  • The amount of time before an offer can be accepted
  • careful drafting of the provisions
  • mention the exceptions, if there are any
  • ensure that the RoFR does not include preferred stock as most investors always want more control in the company

Pros and Cons of a RoFR Clause

A ROFR investment is a great way to invest in a company without having to be an expert on the company’s industry.

The advantage of a ROFR investment is that you can invest in a company without having to be an expert on the company’s industry. You can also have voting rights, which means that you can have input into how the company is run.

RoFR provides the VCs and other investors to get control over the holding rights, giving more significance and control over the voting power, which can significantly change the situation at times.

RoFR acts as an insurance policy for the VCs and other investors as they will not lose any equity holding rights in the company until they reject the offer of purchasing the new shares.

The disadvantages of a ROFR investment are that the investor does not get any dividends or other distributions from their shares until they sell them.

RoFR can be a hurdle for the founders as it will restrict them from negotiating with multiple buyers who would be purchasing the shares at the price they decide.

RoFR can also lead to a reduction in liquidity in the case of start-ups.

Key Takeaways

Right of First Refusal may be beneficial for the VCs and other investors who have initially made investments as it gives them the power to accept or reject the offer to buy the new stock issues, giving them a choice to accept retaining the holding rights and increasing their shareholdings in the company. However, the Right of First Refusal does not always need to allow them to sort out the upcoming issues regarding the ownership rights or the valuation of their shareholdings.

Considering the founders’ viewpoint, there is a possibility that they can vest the investors’ interest in the business. Right of First Refusal may not be beneficial for the start-ups as it is possible that the Right of First Refusal by VCs can put the founders in a fix by giving more control to them.

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Tyke Editorial Team

Tyke Editorial Team

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