Allen Latta's Thoughts on Private Equity, Etc.
  • Allen's Blog
  • Blog Post Categories
  • Glossary of Private Equity Terms
  • Resources
  • About
  • Contact

Rights of First Refusal: An Overview

2/27/2021

0 Comments

 
Have you heard the term “ROFR” (pronounced “Roafer”)?  This term is well known by professional investors.
 
ROFR means Right of First Refusal.  We will do a deep dive on ROFRs in this post.
ROFRs apply when an existing investor in a company wants to sell some or all of its shares in the company.  If this investor receives an offer from a potential buyer for its stock, the ROFR prevents this investor (known as a “selling stockholder”) from just going ahead and selling its stock to the potential buyer.  The ROFR requires the selling stockholder to offer to sell its shares to the company and/or the other stockholders at the same price and other terms proposed by the potential buyer.  If the company and/or the other stockholders buy all of the stock being sold by the selling stockholder, then the potential buyer loses out.  If, however, the company and/or the other stockholders don’t buy all of the stock being sold by the selling stockholder, then the selling stockholder can go ahead and sell to the potential buyer.
 
ROFRs are very common in venture capital financings.  Venture capital investors want ROFRs so that if an existing investor wants to sell some or all of its stock, the other investors can buy this stock.
 
Mechanics
The way a ROFR works is that if an investor (the “selling stockholder”) receives an offer from a potential buyer (called a “third party”) to purchase some or all of its shares, then that selling stockholder must notify the company and the other investors about the offer, including the number of shares the investor wants to sell (called the “offered shares”), the price and all other terms of the offer.  The company then has a period of time, usually 15 days, to decide how many of the offered shares the company wants to buy, which can be all, some or none.
 
Company Buys All Offered Shares.  If the company decides to buy all of the offered shares, then that’s what happens and the ROFR process ends.  The selling stockholder sells all of the offered shares to the company for on the same terms that were offered by the potential buyer.  The potential buyer loses out.
 
Company Buys Some or None of the Offered Shares.  If the company decides to buy some, but not all, of the offered shares, or decides to buy none of the offered shares (which is common), then the company notifies the selling stockholder and the other investors of the number of shares the company is buying.  The other investors then have the right to purchase the remaining shares on the same terms offered by the potential buyer.  When the company notifies the other investors of the total number of offered shares available to purchase, the company includes in the notice the number of offered shares each stockholder can buy, which is based on the “pro rata” or proportionate ownership of the investors that are covered by the ROFR. 
 
The stockholders then have a short period of time after receiving the notice from the company, usually 10 days, to decide they will buy the shares offered to it.  Typically, they have to buy all shares offered to them, or none; they can’t buy some of the shares offered to them.  If one or more stockholders don’t buy their allotment of offered shares, then the company will send another notice to the stockholders who indicated that they will buy their allotment, and these stockholders can then pick up the slack.
 
After going through this process, the company and the stockholders have to indicated that they will buy all of the offered shares.  If the company and the stockholders don’t indicate that they will buy all of the offered shares, then they lose the right to buy any of the offered shares and the selling stockholder will then sell the offered shares to the potential buyer.
 
Notes
  • Limited to Major Investors.  ROFRs are usually limited to major investors.  The reason for this is that if the company has a lot of stockholders, going through the ROFR process is very complex and burdensome.
  • Stock Options Excluded.  ROFRs don’t cover stock options or warrants.  Only major investors who own lots of common or preferred stock have the ROFR.
  • Excluded Transfers.  ROFRs are designed to cover all transfers of stock, but there are a few exemptions.  Venture capital funds sometimes need to transfer the stock to an affiliate (such as a different fund managed by the venture capital firm), and so these types of transfers are often allowed.
  • Non-Cash Consideration.  Sometimes a prospective buyer will offer a selling stockholder something other than cash for the offered shares.  Sometimes this can be shares of stock of another company, services or some type of property.  In this case, the company’s board of directors determines the fair market value of this non-cash consideration, and the company and stockholders can pay cash based on this fair market value.
  • Variations.  There are many variations to ROFRs.  One company-favorable variation is where the ROFR is an exclusive right of the company and not the other stockholders.  The company can exercise its right, can waive it, or can assign (transfer) it to one or more stockholders.  But similar to above, if the right isn't exercised within a certain period of time, then the right terminates and the transaction can occur.  This variation makes it easier for the company to approve secondary sales by existing stockholders if it wants to do this for an existing officer or employee.  This variation also give the company more control over its capitalization table.  If there's a stockholder that's been really helpful to the company, the company can assign its ROFR to this stockholder to reward this stockholder.
  • Documents.  The ROFR can be its own separate agreement, or the ROFR can be contained in a stockholder agreement or investor agreement.
  • Co-Sale Rights.  It is common for ROFRs to be paired with co-sale rights, which apply if a ROFR is not exercised, and enable other stockholders to participate in the sale.  We sill discuss co-sale rights in a future post.
 
Example
A1Z2 Technologies, Inc., an early-stage enterprise software company, has 2 founders who each own 250,000 shares of common stock.  The company also issued 100 shares of common stock to two vendors who took stock in exchange for services.  The company then held a Series A Convertible Preferred Stock financing and raised $1 million from three venture capital firms.  In this Series A financing, the company issued 100,000 shares of Series A preferred stock to three investors at $10.00 per share.  The company also has a stock option pool of 50,000 shares, of which 10,000 have been granted.  Here’s the post-Series A cap table: 
Picture

​​As part of the Series A financing, the investors obtained a ROFR that covered all investors owning 20,000 shares or more (“major stockholders”).  This means the founders and the venture capital investors are covered by the ROFR.  The two vendors (with 100 shares each) and the stock options are excluded from the ROFR.  The ROFR provides that the company and the other stockholders have the right to purchase any offered shares at the price and on the other terms of any offer.
 
A year later, Brawny Tech Ventures receives an offer from Really Smart Ventures to buy all of Brawny Tech’s 20,000 Series A shares for $50.00 each in cash.  This offer is five times what Brawny Tech paid and would be a great return for Brawny Tech.  Brawny Tech sends a notice to the company about the offer.  The company decides not to buy any of the offered shares.  Because of this, the major stockholders have the right to buy all of Brawny Tech’s 20,000 on a pro rata (proportionate basis).  The table below shows the pro rata amounts and the number of Brawny Tech shares each major investor can purchase:
Picture
​Each investor buys their pro rata portion of Brawny Tech’s shares at the $50.00 cash price.  Because the ROFR has been exercised in full, Really Smart Ventures loses out.
 
Here’s the cap table after the ROFR:
Picture

​Let’s check this.  First, the number of shares of common stock outstanding before and after the ROFR remain the same.  This is correct.  Only shares of Series A Preferred Stock were sold.  Second, the number of Preferred Stock outstanding before and after the ROFR remain the same.  What has changed is the number of Series A shares each investor owns.  The founders each purchased 8,621 shares of Series A stock from Brawny Tech Ventures, and Cof-Mor Ventures and Strambold Ventures purchased 1,724 and 1,034 shares of Series A stock from Brawny Tech Ventures.  Finally, the number of fully diluted shares (610,200) didn’t change.  This is correct.  All that happened was that Brawny Tech sold its shares to existing stockholders and not the company.  If the company had purchased shares, the shares the company purchased would be retired and this would reduce the number of shares outstanding.
 
I hope post has helped your understanding of ROFRs.  If so, give it a Like!

​
© Allen J. Latta.  All rights reserved.

0 Comments

Your comment will be posted after it is approved.


Leave a Reply.

    About this Blog

    This Blog is a collection of thoughts on a variety of topics of interest to me, including:
    • Private Equity
    • Buyouts
    • Growth Equity
    • Venture Capital
    • Corporate Finance
    • Investment Banking
    • IPOs
    • M&A
    • Technology
    • Economics
    • Law
    I hope you find this blog of interest.
    View my profile on LinkedIn

    Categories

    All
    Anti-Dilution
    Berlin
    Board Of Directors
    Brazil
    Buyouts
    California
    China
    Cleantech
    Corporate Finance
    Corporate Venture Capital
    Crowdfunding
    Dilution
    Dividend Recap
    Economics
    Emerging Managers
    Endowments
    Entrepreneurship
    Europe
    Fund Terms
    General
    Growth Equity
    Healthcare
    India
    Innovation
    Investment Banking
    Ipo
    Israel
    Law
    Legal
    Libor
    Life Sciences
    Listed Private Equity
    London
    Los Angeles
    LP Corner
    M&A
    Mexico
    New York
    Pensions
    Politics
    Private Equity
    Public Stocks
    San Francisco
    Secondaries
    Secondary Exchanges
    Silicon Valley
    South America
    Speaking
    Stock Market
    Stock Options
    Tax
    Technology
    Travel
    United Kingdom
    Valuation
    Venture Capital
    Venture Capital Deal Terms
    Webinars


    Archives

    October 2021
    August 2021
    July 2021
    April 2021
    March 2021
    February 2021
    January 2021
    December 2020
    November 2020
    October 2020
    September 2020
    August 2020
    July 2020
    June 2020
    May 2020
    April 2020
    February 2020
    December 2019
    November 2019
    October 2019
    September 2019
    August 2019
    July 2019
    June 2019
    April 2019
    March 2019
    February 2019
    January 2019
    December 2018
    November 2018
    October 2018
    September 2018
    August 2018
    July 2018
    June 2018
    May 2018
    April 2018
    March 2018
    February 2018
    January 2018
    December 2017
    November 2017
    October 2017
    September 2017
    August 2017
    July 2017
    June 2017
    May 2017
    April 2017
    March 2017
    February 2017
    January 2017
    December 2016
    October 2016
    September 2016
    August 2016
    July 2016
    June 2016
    May 2016
    April 2016
    February 2016
    January 2016
    November 2015
    October 2015
    July 2015
    June 2015
    May 2015
    April 2015
    March 2015
    February 2015
    January 2015
    December 2014
    November 2014
    October 2014
    September 2014
    August 2014
    July 2014
    June 2014
    May 2014
    April 2014
    March 2014
    February 2014
    January 2014
    November 2013
    October 2013
    September 2013
    August 2013
    July 2013
    June 2013
    May 2013
    April 2013
    February 2013
    January 2013
    December 2012
    November 2012
    October 2012
    September 2012
    August 2012
    July 2012
    June 2012
    May 2012
    April 2012
    March 2012
    February 2012
    January 2012
    December 2011
    November 2011
    October 2011


    Copyright Notice:

    ​All original works on this site are 
    © 2011-2020 Allen J. Latta. All rights reserved.  Neither this website nor any portion thereof may be reproduced or used in any manner whatsoever
    without the express prior written permission of Allen J. Latta.

    LP Corner® is a registered trademark of Campton Private Equity Advisors.  Used with permission.

    DISCLAIMER:  Readers of this Blog are not to construe it as investment, legal, accounting or tax advice, and it is not intended to provide the basis for the evaluation of any investment.  Readers should consult with their own investment, legal, accounting, tax and other advisors to the determine the benefits and risks of any investment.

    Private equity investments involve significant risks, including the loss of the entire investment.

    This Blog does not constitute an offer to sell or the solicitation of an offer to buy any security.

Copyright © Allen J. Latta.  All rights reserved.