Term Sheets: What is the right of first offer (ROFO)?
This week we continue our series on key VC financing deal terms.
This week’s question: What do I need to know about the right of first offer?
Our answer: The right of first offer (ROFO) (typically provided in the Investors’ Rights Agreement) allows certain major investors to buy a pro rata share of any new securities before your startup offers them to others. The ROFO helps investors maintain their ownership percentage by giving them a set window to participate in the new issuance of securities. And if any of the new securities go unclaimed, the participating investors often have an opportunity to purchase its pro rata share of the remainder. Then after this process, your startup may offer any remaining new securities to others, but only on terms that are at least as favorable as those originally offered. Our recommendation is to ensure that your ROFO matches the NVCA model documents as a baseline and that you consider adding potentially favorable carveouts such as a forfeiture clause or a retroactive participation right (described below).
Key Considerations
1. Exempted Securities. Your ROFO provision should carve out “Exempted Securities” to avoid inadvertently triggering the ROFO. These exemptions should be defined in your startup’s Certificate of Incorporations and include shares issued under equity incentive plans, upon conversion of convertible securities (e.g. SAFEs), or in strategic transactions (e.g. M&As or commercial deals with customers or vendors).
2. Standard Limitations. While investors typically have the right to transfer the ROFO, it’s critical to restrict these transfer rights to parties that are not competitors or subject to public disclosure obligations such as the Freedom of Information Act. This reduces the risk of equity ownership, and thereby trade secrets or sensitive proprietary information, being exposed to competitors or becoming publicly accessible.
3. Forfeiture and Retroactive Terms. To preserve flexibility, consider including a forfeiture clause that terminates the ROFO if a major investor fails to purchase its full pro rata share because this incentivizes ongoing participation and prevents non-participating investors from complicating the company’s ongoing cap table strategy. To allow faster action without materially breaching the ROFO, also consider pushing for a post-issuance notice allowing investors to buy after an issuance closes rather than following the full ROFO process beforehand.
Why It Matters
A ROFO is a standard protection for investors to maintain their ownership and influence without re-negotiating terms for every new financing. That said, when properly drafted and strategically negotiated, a ROFO can still maintain company’s flexibility for future issuances and serve as a useful tool to keep investors engaged.
