This short article explains how granting a right of first refusal within a shareholders' agreement gives existing owners additional control over the entry of new ones.
A right of first refusal (abbreviated to ROFR) is also known as a right of pre-emption or a right of preference. We use the terms interchangeably.
What is right of first refusal?
Right of pre-emption gives shareholders the right to buy shares from another shareholder on the same terms as agreed with an external party before the external party may buy them. In other words, ROFR is the right to buy existing shares before outsiders can.
Why is a right of preference beneficial?
Right of first refusal has three benefits:
Controlling who comes in
Right of pre-emption gives existing shareholders more control over the entry of new shareholders. This may be important if the company has secrets that shareholders wish to protect, or if shareholders wish to ensure that only certain people (such as family members) are owners.
Maintaining the balance of power
A ROFR can maintain the relative balance of power between shareholders. This might be important for large investors who want to be able to exert the greatest influence on the direction and operations of the company. For example, if a minority shareholder agrees to buy the shares of other minority owners then he may be able to threaten the control by the largest shareholder. A right of preference may give the majority shareholder the right to buy a share of the stock being sold and thus maintain his voting power relative to the other shareholders.
Discouraging new investors from investing
A right of preference is usually a right to buy on the same terms. Therefore, terms must have been agreed. To get to this point, the buyer will have had to spend time and money performing due diligence. If there is a ROFR, the buyer may be dissuaded from spending the time investigating the company because he knows that other shareholders are unlikely to let him buy in anyway.
If the existence of a ROFR is a sufficient disincentive to exiting, it has the effect of making it more attractive to shareholders to exit the company (sell) together rather than selling individually. So, a ROFR can bind shareholders together in the achieving the same goals so as to maximise the value of the company and sell at the same time.
Rights of first refusal often add months to the transaction time and they create great uncertainty for potential third party buyers as well as for selling shareholders.
Pricing
The price at which the outsider makes an offer is likely to influence whether the existing owners take up the right of preference, or whether they 'let' the new investor come in.
If the price is less or equal to the value that the shareholders perceive the company to be worth, then shareholders (who are likely to have better information to allow them to assess how much the company is worth) are likely to invoke the right and buy the shares themselves.
If the existing shareholders believe that the hopeful buyer is offering a price much higher than the company is worth, then they may not use the right of first refusal, but the buyer knows that he has paid a far higher price than other (more knowledgeable) owners would.
How a right of preference works
The mechanics of how a ROFR works depends completely on what has been agreed in the shareholders' agreement. There are many things that can be varied, for example, the existing shareholders may be given the right to buy on preferential terms (such as price), only some shareholders may have the right, the company may have the right as well, or the right may only exist in certain circumstances.
Usually, any new owner must agree to the same shareholder terms.
What if an existing shareholder can't afford to buy more shares?
If a shareholder can't raise the money to buy the shares, then he can't participate. These are the rights to be able to buy, not the rights to stop another shareholder from selling.
However, having either of these rights confers another benefit, and that is that a shareholder must be told before an issue or sale takes place. Depending on the circumstances, he may be able to stop it or act in such a way as to minimise his disadvantage from it occurring. Without the right, events may be able to occur without shareholders being aware that their control or investment value is about to diminish.
Further information and documents
If you are interested in reading about other types of clauses and provisions found in a shareholders agreement, we have separate articles covering: deadlock provisions, dilution and pre-emption rights, drag along clauses, and tag along clauses
If you are looking for an agreement, we have a number of shareholder agreement templates for UK companies.