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.

Comments

  • nevergonna

    Would an individual investor's transfer to his investment holding company count as a “transfer” subject to the ROFR under most such agreements?

  • http://www.startupcompanylawyer.com Yokum

    @nevergonna – it depends on the exact lanugage of the agreement. It might trigger the ROFR in some forms and it might not in others.

  • nevergonna

    Thanks! Under this particular one, that seems to be the case. I think we're going to then need a waiver by the other investors. It just seems weird because the investor would just be transferring it from ownership as an individual to entity ownership. I'm just curious what the potential objections could be to that given that other angels invested via an entity.

  • nevergonna

    Would an individual investor's transfer to his investment holding company count as a “transfer” subject to the ROFR under most such agreements?

  • http://www.startupcompanylawyer.com Yokum

    @nevergonna – it depends on the exact lanugage of the agreement. It might trigger the ROFR in some forms and it might not in others.

  • nevergonna

    Thanks! Under this particular one, that seems to be the case. I think we're going to then need a waiver by the other investors. It just seems weird because the investor would just be transferring it from ownership as an individual to entity ownership. I'm just curious what the potential objections could be to that given that other angels invested via an entity.