Right of First Refusal: Everything You Need to Know
A right of first refusal, also called ROFR, a first right of refusal, or a last look provision, gives the opportunity for a business transaction first.7 min read
What is a Right of First Refusal?
A right of first refusal, also called an ROFR, a first right of refusal, or a last look provision, gives a person or company the opportunity to start a business transaction before anyone else can. It could provide the first chance to buy stocks or real estate at the same price and terms as another offer. If the holder of the right of first refusal declines, the owner of the asset can sell it to whomever they want.
There's even an ROFR in many child custody agreements. It requires that one parent offer the other parent the chance to watch the kids before using a family member or outside child care.
A Right of First Offer: What is it?
A right of first offer or ROFO requires owners to tell the holder first when they plan to sell an asset. Then the holder of the ROFO has the right to make the first offer on the business, stocks, or property. The seller can accept or reject the offer, speak to other buyers, and negotiate with the holder. An ROFO can reduce transaction costs and save time. Selling a business often takes lawyers, investment advisors, and accountants. Buyers and sellers are motivated to negotiate quickly to cut costs, so buyers usually give fair offers. Sellers can wait for better offers, but buyers could reduce their bids.
Why is a Right of First Refusal Important?
Many commercial leases have these provisions. They give businesses more security if a landlord goes bankrupt or decides to sell the property they rent. Venture capital investors and other companies often use the right of first refusal to get the best price on stocks or entire companies. Holding an ROFR and waiting is usually more profitable that buying an asset right away. Also, businesses partners in joint ventures usually grant each other this right so they can keep a newcomer from buying a stake in their firm if one of them wants to sell their shares. Shareholder agreements in private companies often have similar terms. A publisher could even ask for the right of first refusal on future books from a new author. If no one is already holding a right of first refusal for a property or company, the first bidder can ask for it or the seller can offer it to attract buyers.
Some Examples of a Right of First Refusal
A real estate owner wants to sell to a purchaser for $1,000,000 with certain terms and conditions. Since a third party has a right of first refusal to buy the real estate, the owner must offer it to the holder of the ROFR with the same terms as the buyer's offer. The buyer can only get the real estate if the holder refuses. An ROFR is essentially an option to buy a property before it's sold to another buyer. The seller and the holder can choose to agree on a price and other terms in the ROFR or negotiate later. The option could end at a specific date in the future, and the owner doesn't have to sell if the terms aren't already established.
A right of first refusal can also be on each stock purchase or grant agreement or it can be in a startup's bylaws. Some startups use both methods, which is called the belt and suspenders approach.
A right of first refusal keeps the person holding it from losing an essential asset. Many commercial tenants prefer to lease premises, but they would buy to prevent eviction by a new owner. A right of first refusal gives tenants a chance to buy and stay at their location.
A holder and a buyer negotiate sale terms for a certain period. Then, the buyer must sell if the holder wants to buy within that time. For example, two parties could agree that 100 acres worth $100,000 now will rise 3 percent per year in value, with or without compounding. An ROFR can also give holders the right to match any offers from potential buyers. Holders pay for the right of first refusal in many agreements or contracts. If the holder can't meet future terms, the seller can sell to anyone. Some agreements only let the holder make an offer at the end of the term, while people can use others anytime. ROFRs usually last one or two years since longer terms are riskier.
Reasons to Consider Using a Right of First Refusal
- The terms of an ROFR are very customizable.
- An ROFR lets the holder reserve the option to buy an asset later.
- It can make the sales process faster and help sellers save time and money, especially in real estate.
- It can help landlords attract tenants.
- The holder can benefit from real estate or business improvements by owners if he or she decides to buy the property.
- A startup with the right of first refusal can stop an external buyer from stepping in when a current stockholder wants to sell their stock. They can offer the same deal to the current stockholder and keep their shares from being diluted.
Reasons to Consider Not Using the Right of First Refusal
- If the ROFR provision doesn't include some terms the holder wants initially, he or she may decide not to make the purchase.
- If other bidders find out about it, a right of first refusal clause could lower prices or make attracting buyers difficult. For example, a landlord might have trouble finding buyers if a tenant has an ROFR.
- It also limits owner's flexibility, especially their ability to sell and seek buyers.
- If a lender holds a right of first refusal on a loan's financing, it has the right to match any other company's terms. This can ruin a sale or refinancing.
- These provisions are complex and confusing, so you shouldn't try to use them without a lawyer.
- Some ROFRs have short response periods that make it hard for holders to use them. According to the Commercial Observer, the usual response period is only 30 days.
- Only the holder can use an ROFR, so he or she often can't tell a friend or family member about the opportunity or make the purchase and then decide to flip it.
- A real estate agent working for a buyer can't get a commission if the holder decides to exercise their right of first refusal.
- When an investor receives an ROFO or ROFR notice, he or she may not be prepared for a large transaction. However, investors often lose their rights if they decline.
Right of First Refusal Tips
- You should specify exactly what real estate is subject to the right of first refusal, as well as what will happen if the owner wants to sell an additional property or part of the original property. Use an allocation of the purchase price or a formula to determine the correct price.
- An ROFR should address what will happen if a purchase offer is for a property instead of cash. It should include a way to determine the fair market value of the property so that the holder of the right can substitute cash.
- Provisions about timing should be carefully drafted. The owner should provide notice of an offer to the holder of the ROFR within a certain number of days, and the holder should have a chance to exercise the right within a certain number of days. Remember to specify the ways the owner can give notice, like certified mail or delivery, and the date when the right ends. Closing or notice of another offer should also happen within a certain number of days.
- A holder of a right of first refusal can transfer the right to a third party unless the terms prohibit transfers. An ROFR should be binding for entities or trusts affiliated with the owner or under control of the owner. It should also be binding if the owner has a direct or indirect interest in the property.
- An ROFR should clearly state any exceptions. For example, most agreements let owners sell or transfer property to a trust or to family members without offering it to the holder of the ROFR. The agreement should also say what will happen if the owner dies.
- If the holder of a right of first refusal declines, the property either won't be subject to an ROFR or the right will continue with the new buyer. Some agreements require an owner to extend an offer to the holder again after a refusal.
- If the holder accepts the right but doesn't complete the transaction, the right is usually extinguished. Other agreements require the right of first refusal to continue if the property is sold to a third party. Without clear provisions, there could be differences in interpretation.
- Slight variations to the offer by the owner and the holder of the ROFR are usually acceptable. Many agreements say that parties can't materially vary from the terms of the original offer, but people often argue about which changes are material. Being able to make changes increases flexibility for both parties and makes responding to problems easier.
- An ROFR can be in each stock purchase or grant agreement, or it can be in a startup's bylaws. Some startups use both methods, and this is called the belt and suspenders approach. Putting a right of first refusal in the bylaws keeps companies from needing to put them in each stock agreement. If your startup goes through a seed or venture capital round, it could have a right of first refusal document for the startup or certain securities used in the investment.
- Make sure that a right of first refusal provision in the bylaws doesn't include preferred stock since most investors want more control of their investments. An attorney should look at the bylaws before investment, even if the investment structure is a security like a convertible note or convertible equity.
If you need help with your right of first refusal agreement or other legal matters, you can post your question or concern on UpCounsel's marketplace. UpCounsel only accepts the top 5 percent of lawyers to its website. The site has a diverse choice of the nation's best startup attorneys. You can easily find a lawyer to help you negotiate or tell you about other aspects of your business. Lawyers on UpCounsel come from excellent law schools like Harvard Law and Yale Law. They have an average of 14 years of legal experience, and many work with or on behalf of companies like Google, Stripe, and Twilio.