Understanding Termsheet: Right of First Refusal
The Right of First Refusal clause (RoFR) is actually an amalgamation of rights which are usually demanded by investors. The logic of having a right of first refusal is to retain the ability (for the investor) to participate in subsequent rounds of funding, when those rounds of funding happen.
[Through this ability to participate, the investor seeks to maintain or increase the percentage of shareholding he / she started off with in the company - that is why many RoFR clauses, there is a condition of proportionate offer, which means that the Founder must offer the investor an opportunity to buy shares enough to retain the share of the investor]
In effect then, the RoFR consists of two parts:
A. An obligation to offer the original investor an opportunity to purchase shares when the Founder wishes to dilute stake
B. A duty to sell or enable the sale of the shares of the original investor before selling the shares of the Founder to a prospective investor (also called a right of co-sale)
What should you watch out for while agreeing to this clause?
First of all, be careful about the exact wording of this clause. In most deals where the amount being invested in low, the upside for the investor is the possibility of a future round of investment.
Consequently, when the Founder tries to raise a round in the future (say a Series A) he / she will have to negotiate this with the original investors, and maybe get the additional investment from them instead of the proposed investors. Never a bad thing to cultivate a long-lasting relationship with the original investors, but you need to ensure that no strategic interests with are being sacrificed by agreeing to the Right of First Refusal.
One point that may be made here is that the right of first refusal will not apply in the cases where the proposed investor offers a significantly higher valuation. Here the Founder is only under an obligation to offer to the original investor an opportunity to participate at the same valuation as the proposed investor and not at the previous valuation. So while this right is restrictive, it is not by any means financially harmful to the Company.
You can have it too!
An interesting thing about shareholder rights and the right of first refusal in particular, is that every shareholder can have this right. It is not limited to one class of shareholders or the investor.
So while getting into an agreement, depending on your bargaining power, you can ask that you be given the right to refuse as well. The result of this will be that if the investor wants to sell his stake to a third party whom you feel could harm the business or not optimally contribute, you could have the right to purchase the equity in place of the undesirable investor.
In most cases, and particularly for early stage investments, this is in the realm of fantasy – having said that, if you can retain the right to be offered the shares of the investor for purchase before the prospective investor purchases them, that is certainly a good position to be in.
[About the author: Contributed by Hrishikesh Datar, founder of vakilsearch.com, online legal services provider (Legal Advice, Legal Documents & more.]
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