What is a right of first refusal and co-sale agreement?
September 17, 2007
The right of first refusal and co-sale (”ROFR/Co-sale”) work together to prevent a founder or major common shareholder for selling shares without the company and the investors being allowed to purchase the shares or participate in the sale of the shares. Below is a typical term sheet provision.
In the event [__________] proposes to transfer any Company shares, the Company will have a right of first refusal to purchase the shares on the same terms as the proposed transfer. If the Company does not exercise its right of first refusal, holders of Preferred will have a right of first refusal (on a pro rata basis among holders of Preferred) with respect to the proposed transfer. [Rights to purchase any unsubscribed shares will be reallocated pro rata among the other eligible holders of Preferred.] To the extent the rights of first refusal are not exercised, the holders of Preferred will have the right to participate in the proposed transfer on a pro rata basis (as among the transferee and the holders of Preferred). The rights of first refusal and co-sale rights will be subject to customary exceptions and will terminate on an initial public offering.
The items typically negotiated in the ROFR/Co-sale include:
- Common holders subject to the ROFR/Co-sale. Generally, investors will want holders of large amounts of common stock to be parties to the ROFR/Co-sale. The company (and founders) will want to minimize the number of holders of common stock that need to be subject to the ROFR/Co-sale. The hassle associated with a large number of parties becomes evident in subsequent rounds of financing when the ROFR/Co-sale agreement needs to be amended.
- Exceptions to the ROFR/Co-sale. Founders will want various share transfers to be exempt from the ROFR/Co-sale such as transfers to family members or for estate planning purposes. In some cases, a founder may want to transfer up to a certain number of shares each year without being subject to the ROFR/Co-sale.
- Minimum investor shareholding to have ROFR/Co-sale rights. The company may want to limit the rights to investors that hold a minimum number of shares.
The ROFR/Co-sale forces a founder to provide written notice to the board and the investors of any potential transfers, which allows the company and the investors time to evaluate if they want to purchase (or participate in the “co-sale” of) the shares. I have never heard of a co-sale right actually being used, although I know that lots of companies remind former founders about their ROFR obligations.
The ROFR/Co-sale agreement rarely receives more than cursory comments in a typical venture financing.
What is a right of first offer or right to maintain proportionate ownership in future financings?
September 1, 2007
A right of first offer allows an investor to purchase its pro rata percentage of issuance of new securities until an IPO. Below is a typical term sheet provision.
Each holder of Series A Preferred will have a right to purchase its pro rata share of any offering of new securities by the Company, subject to customary exceptions. The pro rata share will equal the ratio of (x) the number of Series A Preferred shares held by such holder (on an as-converted basis) to (y) the Company’s fully-diluted capitalization (on an as-converted and as-exercised basis). This right will terminate on an IPO.
The items typically negotiated in the right of first offer provision include:
- Major investor. Like information rights, the concept of “major investor” is often used to limit the investors that receive preemptive rights. The number of shares that an investor needs to hold to have these rights is typically set low enough to ensure that the smallest venture fund (or significant angel) in a syndicate receives the rights and high enough to avoid giving rights to numerous small investors.
- Accredited investors. Sometimes, the right of first offer will be limited to accredited investors (to be covered in a future post). Federal and state securities laws limit offers and sales of securities to a limited number and certain types of investors.
- Percentage calculation. The pro rata calculation may be tweaked by aggressive investors so that the denominator in the formula is the aggregate number of preferred shares, which would result in existing investors having the opportunity to purchase 100% of the securities offering in the financing.
- Carveouts. The right of first offer typically not apply to certain issuances of securities. This list is generally the same as the types of issuances that do not trigger anti-dilution.
- Super pro rata rights. Investors sometimes ask to have a right to purchase more that their pro rata percentage ownership. This is not a common term in a typical venture financing. However, it may be requested in an early stage financing where the investor did not obtain a large percentage ownership because the company wanted to limit dilution, but investor expects to invest in additional rounds and wishes to increase their percentage ownership. Please read the commentary from AsktheVC and Venture Hacks for more thoughts on this provision.
- Over-allotment. If some investors with pro rata rights do not fully participate, then the participating investors may want the right to purchase the shares that the non-participating investors did not purchase. This potentially adds additional delay to completing the financing due to the need to comply with various notice periods for the initial offer and the over-allotment.
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