What is a Right of First Refusal (ROFR)?

Shareholders often want certain protections to safeguard their interests, especially when the ownership structure shifts. This is where the Right of First Refusal (ROFR) proves valuable. Though more commonly associated with real estate, ROFR is crucial in stocks and shares, offering preemptive rights to existing shareholders or investors.  

This blog will break down ROFR, how it works, its benefits, and potential drawbacks.  

What is Right of First Refusal (ROFR)?  

A Right of First Refusal (ROFR) gives shareholders the chance to buy shares from a selling shareholder before they are made available to an external buyer. Essentially, shareholders with ROFR have the option to match or exceed the price and terms proposed by a third-party buyer, allowing them to maintain control over the company’s ownership structure and prevent unwanted parties from acquiring a stake.  

For example, if a shareholder wishes to sell their equity in the company, those holding ROFR rights can decide whether they want to match the offer. If they decline, only then can the shareholders proceed with the sale to a third party. ROFR clauses are typically included in shareholder agreements to maintain a level of control over the ownership distribution within the company.  

How does Right of First Refusal (ROFR) work?  

When a shareholder chooses to sell their shares to an external party, the Right of First Refusal (ROFR) requires that the shares be offered first to those holding ROFR rights. These shareholders have the option to purchase the shares on the same terms, including price, as proposed by the third-party buyer. If the shareholders with ROFR choose not to exercise their rights, the selling shareholder is then free to proceed with the sale to the third party under the same or better terms. This process ensures that the existing shareholders have the first chance to keep control within the company, hence the name "Right of First Refusal.”  

Benefits of Right of First Refusal  

There are several key benefits of having a Right of First Refusal clause:  

1. Protection against unwanted ownership changes: ROFR helps shareholders or investors prevent unwanted third parties from acquiring a stake in the company. This is especially important in early-stage companies, where the entry of a new investor could alter the dynamics of decision-making.  

2. Maintaining ownership control: It offers existing shareholders the opportunity to maintain or increase their ownership percentage by allowing them to purchase shares that become available.  

3. Investment security: ROFR serves as a security mechanism for investors. They are assured that their stake in the company won’t be diluted by new entrants without being given the chance to prevent it.  

Drawbacks of Right of First Refusal  

However, ROFR is not without its downsides. Some potential drawbacks include:  

1. Complexity of transactions: The process of selling shares can become cumbersome and time-consuming due to the requirement to notify all ROFR holders and wait for their responses. This can deter external buyers or drag out negotiations.  

2. Lowered interest from external buyers: Third-party buyers might be discouraged from making offers if they know that shareholders with ROFR can simply match their offer and purchase the shares themselves. This can limit the market for shares and reduce liquidity.  

3. Potential conflicts among shareholders: ROFR may lead to friction between shareholders if some wish to sell their shares but are unable to do so because others exercise their rights. This dynamic can cause tension within the ownership structure.  

Bottom line  

The Right of First Refusal (ROFR) safeguards shareholders and investors, allowing them to retain control over ownership changes and preserve the company’s structure. While it protects against unwanted third-party investors and helps maintain company culture, it can also add complexities to transactions. ROFR serves as a strategic tool for those looking to protect their stakes, ensuring that any shifts in ownership occur on terms that benefit the existing shareholders first.

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