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.

Comments

  • Terrence Smith

    Yokum,

    Although the ROFR is a very common provision in financings, do you believe that potential investors may limit engaging seriously with a potential investment target if they feel that an existing investor may “match” them, by exercising an existing ROFR?

    I envision that this would depend upon the percentage to which this ROFR applies. I am curious to know whether in practice you have experienced such a scenario.

  • http://www.startupcompanylawyer.com Yokum

    @Terrence – As a practical matter, no. A right of first offer is in almost every financing. As a practical matter, I don’t think potential investors even consider the issue. If a company is meeting with a VC, there is an expectation that the company wants the VC’s money and that appropriate steps will be taken to facilitate it. This is, of course, different from a right of first refusal on a sale of company.

  • YW452

    I thought ROFR means when an investor/founder is trying to sell its share to any other third party, the company have the right to purchase from the selling investor/founder the shares it intents to sell at a matching price. I think it does have an effect to repel third party to buy shares from the investor/founder. Am I correct?
    I understand that the right of first offer does not really affect the third party investor because the right of first offer “attaches to”, rather than “replaces”, the shares the third party investor wants to buy.
    Let’s say a company initially have a Series A shareholder with 20% interest in the company, and the remaining 80% is held by founders. If a Series B investor wants to invest in the company 2 million for a 20% interest, then, the Series A investor, if he wants to maintain a 20% interest in the company, has to use the right of first offer to invest an additional 400k (if he doesn’t invest, it would be diluted to 16%, so he has to pay for the 4%, which is 400k in our case) to maintain the 20% interest . After exercising his right of first offer, the company would be 20% owned by each of the Series A and Series B investor, and the founders will own 60%. Am I right?

  • http://www.startupcompanylawyer.com Yokum

    @YW452 – See the post “What is a right of first refusal and co-sale agreement?” As a practical matter, almost all founders are subject to a RFR/Co-sale (right of first refusal and co-sale), so I’m not sure it is meaningful to consider whether the RFR/Co-sale inhibits third parties from making offers to purchase the founders’ stock. In most cases, a third party would want newly issued preferred stock, not the common stock typically held by founders.

    The RFO (right of first offer) typically allows an investor to maintain its percentage ownership on a fully-diluted basis. You math is not correct because additional shares issued to the Series A investor will dilute the Series B investor’s goal of owning 20%, so there is a circular formula that needs to be solved for.

    Let’s assume there are 100 fully-diluted shares, 80 common and 20 Series A.

    The Company proposes to sell 25 shares of Series B, so that the Series B holder would have 25/125, or 20%. The right of first offer would allow the Series A investor to purchase 20% of 25 shares, or 5 shares. However, this would mean that the Series B holder has less than 20% (20/125). Thus, in order to result in the Series B holder owning 20% and Series A holder owning 20%, you would need to solve for the following equation:

    [X - .2X] / [100 + X] = .2

    where X is the number of shares offered in the financing.

    The answer is X = 33.3, so that the new Series B investor purchases 26.66 shares and the old investor purchases 6.66 shares.

  • YW452

    Thanks so much for the corrections.

  • Terrence Smith

    Yokum,

    I must admit my math skills aren’t ideal, so my apologies if I’m missing something very simple, but if 24 shares of Series B stock is being issued, wouldn’t the percentage be 24/124 (common, Series A, and Series B), not 24/120?

    Thanks.

  • http://www.startupcompanylawyer.com Yokum

    You are correct. I meant 25/125, not 24/120.