We are often asked about the right of first refusal clause (ROFR), and so we thought it would be useful to survey the features of a right of first refusal clause here.
For a business with shareholders holding enough shares to swing the votes on shareholder decisions, a right of first refusal is a mechanism to: (1) prevent an unwanted shareholder from joining the existing shareholders at the voting table - this concept is easy to understand and we will not be discussing this in greater detail in this article; and (2) prevent a sale of shares internally that rebalances voting control of the business.
The right of first refusal clause might appear in the shareholders’ agreement or in some cases, might be directly embedded into a company’s articles of incorporation.
The concept of proportionate interest
To prevent a power imbalance from occurring, shareholders will often require the right of first refusal to buy up to their proportionate interest. For example if they are three shareholders in a business (Shareholders A, B and C) and Shareholder C has decided to sell their shares, then Shareholders A & B who are remaining may decide that they would like to divide the shares of Shareholder C in some way (equally, proportionally based on their existing share holdings, or in some other manner). To prevent argument on the proportions of the split, the shareholders’ agreement will often contain a mechanism that sets out this split to be calculated based on the proportions of each of Shareholders A and B’s holdings prior to the division of the shares held by Shareholder C. The following clause is sample text of a definition of proportionate shareholding.
“Proportionate Interest” means at any time with respect to a Shareholder:
- (i) the Shareholders’ rateable ownership of the Common Shares held by such Shareholder to which this definition is applied (the “Considered Shares”) expressed as a percentage, which percentage is determined by dividing the number of Considered Shares owned by the Shareholder by the total number of Common Shares owned by all shareholders (the “Eligible Shareholder Class”); and
- (ii) in the context of a transfer of shares transaction, if any Shareholder that is eligible to purchase shares available for sale waives its option to purchase such shares (the “Non-Purchasing Shareholder”), the Eligible Shareholder Class shall not include the Non-Purchasing Shareholder in the calculation of the Proportionate Interest.
The rebalancing may require several rounds
In many cases shareholders will decline the right of first refusal. This is because sometimes money is tight, and not everyone will have the funds to pay for shares when offered. Therefore the mechanism of a right of first refusal clause is not just for equal shareholders (in terms of the number of shares held), but are also a useful provision for “minority shareholders” who would like acquire additional shares. The process for dividing up the shares amongst the shareholders who are willing to invest can be a several round affair. To use a pie-eating analogy, in the first round of allocations, the shareholders will first agree first the piece of pie served to them i.e. buy their own proportionate interest, and then divide up the “uneaten pie” or unallocated portion, over several rounds, using fresh calculations of proportionate ownership, until all of the pieces of pie are gone. Sample text of a right of first refusal clause can be found below. As there are many ways to nuance this clause, make sure that you consult with counsel and/or read the text carefully before inserting this text into your agreement.
Right of First Refusal Under an Offer: As long as the aggregate number of Sale Shares to be purchased by the Non-Selling Shareholders is equivalent to the number of Sale Shares offered (“Minimum Share Sale”), each Non-Selling Shareholder holding at least [•]percent ([•]%) of the Voting Shares may:
a. agree to the Redistribution Arrangement;
b. accept the Offer for its Proportionate Interest of the Sale Shares;
c. accept the Offer for any other lesser number of Sale Shares; and
d. accept the Offer for any greater number of Shares than such Non-Selling Shareholders’ Proportionate Interest up to the maximum number of Sale Shares, in the circumstance that other Non-Selling Shareholders have declined the opportunity to purchase their Proportionate Interest of the Sale Shares (collectively, (a) through (d) are the “Right of First Refusal”)(From https://clausehound.com/legal-contract/15815)
Skipping the calculations and making your own decisions on how to divide up the shares
Shareholders often also include a clause to come to a negotiated agreement on redistributing the shares themselves and bypassing the entire calculation mechanism - this is referred to above as the Redistribution Arrangement. Sample language is found below.
Distribution of Offered Shares: Where one or more Non-Selling Shareholders agree to purchase shares under an Offer, the Non-Selling Shareholders may unanimously come to an agreement in writing for the re-distribution of shares received under an Offer in accordance with the Right of First Refusal (as defined below) provisions set out below (the “Redistribution Arrangement”); or, where such purchasers fail to come to a Redistribution Arrangement, the Sale Shares shall be distributed according to the acquiring Shareholders’ Proportionate Interest in the Sale Shares. If any of the Non-Selling Shareholders decide to acquire less than their allocation of Shares, any available shares for allocation will be acquired according to the remaining Shareholders’ Proportionate Interest in the Sale Shares, and such process shall repeat each time that a Non-Selling shareholder opts out of acquiring shares allocated to them, until all shares are acquired.
Takeaways
- When drafting a ROFR give careful consideration to the classes of shareholders who are eligible to exercise the right
- When drafting a ROFR give careful consideration to the classes of shares which are subject to the right, especially if different classes of common shares carry different voting rights
- Pay close attention to any eligibility requirements for exercising the right (eg. a specified % of holdings) to ensure that the clause will work effectively in the particular context