Why Founders Should Deny a Right of First Refusal
- What constitutes a right of first refusal (ROFR)
- Why founders shouldn't agree to a ROFR clause
- How founders can avoid a ROFR
Among many "gotchas" we see when advising founders through M&A and capital raise transactions, a particularly frustrating one for founders is the right of first refusal.
What is the right of first refusal?
Like other minority protections, the right of first refusal (ROFR) is a provision that protects the rights of an investor acquiring a minority stake in a company.
Specifically, a ROFR places an obligation on the company to inform the minority investor if the company receives an offer from another party to invest in or acquire the company. The original investor then has the right to close a transaction on the same terms as the offer.
A situation where we’ve commonly seen a ROFR is in agreements between a young company who receives an investment from a large strategic buyer (often also a customer).
Founders of young companies usually don’t give much thought to the implications of a ROFR—the founder is usually just excited to have a partner. Between the extra capital and a large company’s vote of confidence, a ROFR seems like a minor detail.
If the topic comes up, the investor can spin the ROFR as positive, suggesting that they want to have an opportunity to invest in the future. When that happens, founders usually don’t push back hard enough, even though they can usually avoid a ROFR by pushing a little harder.
When founders let a ROFR slide, unfortunately the term can come back to haunt them.
The Future Implications of a Right of First Refusal
While an investor might suggest that a ROFR is a signal that they want to invest in the future, in reality this term only benefits the investor, not the founder.
Nothing impedes an investor from making a future offer in the absence of a ROFR. The presence of a ROFR, on the other hand, can create a significant downside for founders. Here’s why.
A ROFR can kill a competitive sales process
A key factor for a founder to achieve a strong outcome in the sale of their business is having a competitive sales process. Competition between buyers drives up valuation and improves the terms of the deal.
Competition also incites buyers to escalate their investment in due diligence earlier in the process, which makes them more committed to win the deal. Due diligence represents a significant expense, so if a company expects they can’t reasonably compete to win the transaction, they won’t participate.
Now consider this: you’re a prospective buyer interested in purchasing a stake in a company. But you discover that no matter what, any offer you make, another party has the right to purchase on the same terms before you. How do you feel about that?
Are you motivated to put your best foot forward? Are you excited to invest resources in due diligence knowing that another buyer could piggyback off your hard work and snatch up your acquisition? Probably not.
In this way, a ROFR can dramatically impede the success of your transaction because:
- Less buyers will participate in the process, which makes it less competitive and drives down outcomes.
- Buyers are less likely to escalate their investment in due diligence, reducing their commitment to closing a deal.
- One of your buyers (your original investor) will have access to all information, which inhibits your ability to use uncertainty as a tool to improve the terms of the transaction.
In light of the implications, what seemed like a minor detail can in fact be a weighty dampener on the tone of future transactions. Which is why, as a founder, you should avoid a ROFR in any agreement with a minority investor or partner.
How to Avoid a ROFR
If anyone, whether a strategic buyer or private investor, proposes including a ROFR in the investment agreement, your first recourse should be to just tell them no. In many cases, the buyer/investor will agree to exclude the provision from your agreement.
If, however, the buyer insists on the necessity of a ROFR and you’re eager to raise capital or bring on a partner, you should:
- First, consider your other options. While the stamp of approval of a large company is certainly nice, other partners could help you reach your objectives just as well. Depending on the stage and goals of your company, venture capital and private equity are good alternatives.
- Second, add some nuance to the ROFR. While any ROFR is to the investor’s benefit and the founder’s detriment, you can soften the impact of the ROFR by adding some nuance to the term. For example, you could require the investor to exercise this right within a few days or otherwise forfeit it.
Seeing the End from the Beginning
The right of first refusal is just one of many nuances of buyer/investor relationships that a founder may not give much thought to but that have significant implications. (Another such example is the net working capital adjustment, which can have a significant impact on a founder’s final economic payout.)
As a founder, you shouldn’t expect yourself to know everything about the long-term implications of details like ROFR. You should, however, surround yourself with professionals who can help you see the end from the beginning so that you can achieve the best outcome possible.