One term that often surfaces in secondary market transactions is the “Right of First Refusal” (ROFR). A contractual right that allows the issuer the first right to repurchase shares that are listed on the secondary market, it can offer several advantages, but is not without pitfalls.
A Right of First Refusal (ROFR), often referred to as a pre-emption right, is part of the stock purchase agreement that is signed during a venture capital fundraise. The ROFR requires the stockholder to give the issuer (the company who provided the shares) the chance to purchase the shares back before allowing another party the right to purchase the shares on the secondary market. One important component is that the purchase takes place at the same terms the buyer was intending to purchase the shares. Many companies have a ROFR clause in their documents, making it an important thing for investors to understand.
Rights of First Refusal can impact buyers and sellers of private stock differently. For a seller seeking liquidity, after their shares have been listed on the secondary market and a qualified buyer has been found, the issuer receives notice of the intention to sell the shares. At this point, the company has the opportunity to exercise their ROFR and purchase the shares at the same terms the buyer intended to purchase the shares. The alternate scenario is that the company does not choose to exercise their ROFR and the transaction continues on as originally intended. In either case, the seller receives the desired liquidity and the shares transfer ownership.
From a buyer’s perspective, the process begins in a similar way, but with varying potential outcomes. The buyer chooses to purchase shares on the secondary market and funds the investment. Once the issuer has received notice of intention to sell shares, there are three differing scenarios that can happen:
ROFR Not Exercised
The first scenario that could occur is that the company chooses to not exercise their Right of First Refusal. This is the simplest outcome, as the transaction just continues on as intended.
ROFR Exercised, New Shares Found
Alternatively, the company may choose to exercise their Right of First Refusal. The platform that is facilitating the transaction may then attempt to find new shares at a similar price and terms as the original transaction. The process of finding new shares can be lengthy, and once new shares are found, the notice process starts over. It is possible that the issuer decides to ROFR the new shares as well, and then the process of finding new shares starts over. This can draw out the entire process and make it take months longer than originally intended.
If new shares are found at a materially increased price, the investor(s) will be informed and can confirm their intent to still purchase at the new price.
ROFR Exercised, No New Shares Found
The final scenario is that the company exercises their Right of First Refusal, and new shares are not found at the same or similar terms. This can happen after the initial ROFR, or if the rights are continuously exercised by the company until new shares aren’t found. If new shares cannot be found, then the funds are returned to investors.
However, a key consideration for secondary investors to be aware of is the timeline of receiving their funds back. Dependent on multiple factors, such as how many times the company exercises their Right of First Refusal, the timeline could be expanded and it could take months before the funds are returned to investors.
In conclusion, the “Right of First Refusal” (ROFR) can be a critical aspect of secondary market transactions, particularly for investors and companies dealing with private stock. It can serve as a mechanism to maintain control over the ownership of shares and help ensure that the issuer has the first opportunity to repurchase shares listed on the secondary market. However, navigating the ROFR process may involve important considerations for both sellers and buyers.
In essence, while the ROFR can provide valuable protections for issuers, it can also introduce complexity and potential delays for secondary market transactions. Investors should carefully consider the implications of the ROFR clause in their investment agreements, as well as the potential impact on their liquidity and investment timelines. Clear communication and understanding of the ROFR process can be crucial for all parties involved to help navigate these transactions.
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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.
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