Friday, 22 April 2016

What is a Right of First Refusal ??

When a privately-held company has more than one shareholder, a right of first refusal (“ROFR”... sometimes pronounced as "roofer") is an agreement among them as to how potential sales of shares to third parties are handled.

ROFRs provide procedures on how potential future share sales are managed.


Suppose Sam and Tom each own 50% of a privately-held company that produces video games. Tom is tired of dealing with Sam, and he wants to retire so he has found a buyer willing to pay him for his 50% of the company. Sam is not thrilled with this since he doesn't want to be stuck with a new 50% shareholder he knows nothing about.  Also, Sam would like to own 100% of the company himself, if he can manage it. Sam remembers that when he and Tom executed their shareholders' agreement that there was a ROFR clause included in it. Sam has decided to exercise his ROFR and will pay Tom for his shares at the same price and terms that were offered to Tom by the third-party purchaser.

A background on rights of first refusal

There are essentially two types of rights of first refusal:

 1. Hard right ROFR: This type of ROFR requires that a shareholder who wishes to sell his or her shares to first solicit offers from third parties. The selling shareholder would then take these offer(s) to the other non-selling shareholder(s) and provide them with the opportunity to match the price and terms of the offer. If they cannot, then the selling shareholder is free to sell to the third party purchaser.

    The non-selling shareholder(s) usually prefer this option since it allows them to know who the third-party purchaser is before they have to make a decision. If they do not find the purchaser to be acceptable they may match the offer and buy the shares themselves. It gives the non-selling shareholder a 'line of sight' into who the potential new shareholder would be.
    However, few third-party purchasers will spend the time and money required to submit a formal offer if they knew that there was a ROFR agreement in place that may be exercised by other non-selling shareholders. This type of ROFR could add months to a transaction and adds a tremendous amount of uncertainty to a potential third-party purchaser.
    Most ROFR agreements also require a successful third-party purchaser to enter into the same type of ROFR agreements, which may be a deal roadblock.

    2. Soft right ROFR: This is also called a right of first offer. This type of agreement requires a selling shareholder to first offer his or her shares to the non-selling shareholder at a specific price and terms. If the non-selling shareholders do not purchase the shares at the price set by the selling shareholder, then the selling-shareholder is free to go to the marketplace and find a purchaser willing to purchase the shares, on those terms or better.

  •  This type of arrangement favours the selling shareholder. Since he or she is free to sell above the stated terms, it does not restrict their liquidity of the shares.
  • Non-selling shareholders generally do not like this arrangement since they do not have a line of sight into who the new potential shareholder is before they make their decision.
Regarding either type of ROFR, it would be prudent to provide clear a timeline around the notice period and how quickly a response is required.  Without clear timelines, a party can play the 'waiting game' indefinitely and stall out a potential deal.  Also, the 'rules of the road' must be very clear to all parties as to how the ROFR will be executed.

 A clear definition of “price” and “terms” should be also in place. For instance, compare a $1,000,000 offer that is payable over 36 months, with a moderate level of security to a $925,000 offer that is all cash on the closing date. Deal terms must be evaluated fairly on an “apples to apples” basis.

Keystone Business Valuations
Steve Skrlac, MBA, CFA, CBV

Located in Burlington and offering business valuation services throughout the Greater Toronto Area (GTA).

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