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.