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Starting a business with co-founders or external investors is an exciting venture, but one that requires carefully managing relationships and protecting respective interests. A shareholders’ agreement is crucial for any company with multiple shareholders. It establishes rules around decision-making, share transfers and investor rights. One vital clause often included in the Articles is a ‘first right of refusal’ or ‘right of first offer’ provision, often called ‘pre-emption rights’. Failing to document this properly can lead to disputes over share dilution, loss of control, and even shareholder litigation. This article will explain what a first right of refusal entails, why it’s essential when drafting bespoke Articles, and key negotiation areas.
What is a First Right of Refusal?
A first right of refusal, also known as a pre-emptive right or right of first offer, is a protective clause that gives existing shareholders the first opportunity to purchase shares. This can apply to new shares issued by the company and existing shares that another shareholder wishes to sell to a third-party buyer. It establishes procedures that the directors or the selling shareholder, as relevant, must follow before shares can be issued or transferred.
The core purpose of a right of first refusal when issuing new shares is to prevent unwanted dilution of ownership for remaining shareholders. These rights also help maintain control over who becomes a new co-owner in the company. Moreover, they promote transparency and stability.
How it Works in Practice
To illustrate with an example, imagine a company with three co-founders, Amy, Brian and Charlie, who each own one-third of the company’s shares. If Brian decides to sell his entire 33% stake to an outside investor, the first right of refusal clause would typically require him to follow a set process:
- formally notify Amy and Charlie of the specific share purchase offer received from the third party – typically by notifying the directors, who then notify the shareholders;
- provide details like the sale price, payment terms and any other conditions;
- allow Amy and Charlie a defined time period (e.g. 30-60 days) to exercise their pre-emptive rights;
- if either Amy or Charlie accepts, they can purchase Brian’s shares on those same terms pro-rata; and
- only if both Amy and Charlie decline can Brian proceed with selling to the outside buyer.
This right of first refusal protects the remaining co-founders from having an external shareholder who they do not know holds a reasonably significant stake in their company. They get the first opportunity to purchase those shares instead, which increases their shareholding, and maintains their existing governance rights.
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Tailoring the Provision
When drafting and negotiating this frequently-included clause, there are several key areas companies will want to carefully consider and tailor to their specific requirements, including:
Time Periods
Setting reasonable time periods for shareholders to exercise their rights once receiving a transfer notice. Too short may not allow enough review, and too long creates unnecessary delays in exit events.
Pro-Rata or Full Purchase
This concerns non-transferring shareholders who can only purchase shares proportional to their existing holdings or have the flexibility to purchase any remaining shares others don’t take up.
Additionally, it’s worth considering whether the selling shareholder is permitted to sell some of their shares to the external buyer if existing shareholders want to buy some but not all of their shares.
Share Class Applicability
Specify if the clause applies equally to all share classes or only to particular preferential classes like founders’ shares. Exempting certain classes can incentivise future investors.
Exempted Transfers
Outlining specific scenarios that are exempt from the pre-emptive rights, like transfers between existing shareholders, family trusts, employee share schemes or affiliated entities.
Expiry Periods
To facilitate easier future transfers, clauses where the rights expire after a certain milestone, like an IPO or after an agreed-upon time period, could be included.
Dispute Resolution
Dispute resolution procedures are alternative solutions to any disputes that arise if remaining shareholders cannot agree to exercise their pre-emptive rights after receiving a transfer notice.
Drag and Tag Rights
There are often thresholds that can trigger a sale of the whole company if shareholders want to sell a large enough stake.
The negotiated terms should balance the protection of existing shareholders’ interests and the preservation of shareholders’ flexibility to exit and sell their stake if desired under reasonable conditions.
Why It Matters
First right of refusal provisions promote transparency and prevent uncontrolled share transfers that could dilute the shareholder base. They also prevent undesirable third-party buyers from becoming new co-owners against the wishes of existing stakeholders.
Additionally, a well-drafted right of first refusal in a shareholders’ agreement leaves the door open for future disputes, potential oppression scenarios and conflicting expectations around exit rights. Having this upfront promotes shareholder harmony by contractually enshrining aligned interests.
Conversely, an overly restrictive or imbalanced set of pre-emptive rights that excessively locks shareholders in can deter future investors, limit a company’s ability to conduct capital raisings or incentivise stakeholders through renewed share issues.
As a result, correctly drafting an agreement through multilateral negotiation of reasonable provisions is critical. In doing so, you equip your company with the appropriate degree of shareholder protection while maintaining flexibility and simplifying future exit and fundraising events.
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Key Takeaways
A first right of refusal requires the selling shareholders to offer shares to existing holders first before selling externally. This clause prevents uncontrolled ownership dilution and maintains control over new entrants. It also sets the seller’s procedures, like notification periods and transfer terms.
Key negotiation areas include:
- time periods;
- share class applicability;
- exemptions; and
- dispute resolution.
For founders, it safeguards governance rights and controlling positions when others seek to exit. As for investors, particularly when combined with a tag-along right, it can operate to ensure that the founders cannot sell a controlling stake in the business without either giving them the right to buy the shares from them or participating in the sale alongside the founder. Moreover, correctly balancing provisions promotes shareholder stability and simplifies future exit events.
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Frequently Asked Questions
It requires selling shareholders to offer their shares to existing holders before transferring to third parties. This protects the current shareholder base before outside interests are let in.
Yes, the clause can be tailored to exempt certain types of transfers, like those between affiliates, family trusts or employee share plans. You could also include a mechanism whereby shareholders holding a particular percentage of shares (i.e. 75%) can waive these rights and allow a transfer to a third party without going through the pre-emption rights procedure.
This is negotiable—the clause can apply equally or be limited to certain preferential classes, like founders’ shares if desired to incentivise future investors.
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