Term Sheets: What is the right of first refusal (ROFR)?

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 refusal?

Our answer: The right of first refusal (ROFR) is a standard type of preemptive protection found in VC financings that gives certain investors “first dibs” to buy shares that a key holder (e.g., founder or employee with >1% ownership) proposes to sell to a third-party. The ROFR is intended to give existing major investors a degree of control over future ownership dynamics by allowing them to maintain their ownership stake and prevent unwelcome third parties from entering the cap table. Our recommendation is to pay close attention to the ROFR to ensure it is narrowly tailored by limiting its scope to only give the right to major investors and common stock key holders, keeping the exercise period short, and including exemptions that safeguard your equity management flexibility.

Key Considerations

1. Scope. The ROFR should only apply to (i) major investors (ie. a defined set of investors, typically who hold a minimum threshold of shares) rather than all preferred stockholders and (ii) common stock held by key holders (ie. individuals such as founders who hold a significant portion of the company’s equity, typically at least 1%) to avoid overly broad and administratively complex processes when triggering the right and to prevent future financing complications.

2. Timelines for Exercise. Seek a commercially reasonable but short ROFR exercise period (e.g. 30 days)  to balance giving key holder the ability to close deals efficiently and investors enough time to deliberate. Otherwise, an ambiguous or lengthy window can derail deals and create unnecessary uncertainty.

3. Exempt Transfers. Negotiate for clear and practical exemptions from the ROFR to enable your legitimate asset protection strategies and preserve flexibility for your personal situation without materially undermining the protections for investors. For example, common exemptions you should consider include (i) affiliate transfers (e.g. a founder transfers shares to his/her LLC or personal holding company), (ii) transfers to trusts or family members for bona fide estate or tax planning purposes, (iii) de minimis transfers (typically no more than 3% of total shares) and (iv) transfers approved by the board or a predetermined threshold of investors

Why It Matters

Although the ROFR is a standard provision in VC financings, if drafted without nuance for your personal and your startup’s situation, it can severely restrict your ability to manage your equity and inadvertently create obstacles to future financing. The ROFR when thoughtfully drafted should strike the right balance of protecting investors and preserving your flexibility without it becoming a long-term constraint.