Rights of first refusal are agreements designed to restrict the marketability of ownership positions in a company (or partnership or LLC) to a particular set of owners. They restrict marketability because they discourage third parties from engaging in the time, effort, and expense of due diligence regarding investments.
Rights of first refusal often add months to the time that a transaction could occur, and they create great uncertainty for potential third party buyers as well as for selling shareholders.
Is a Right of First Refusal a Buy-Sell Agreement?
Rights of first refusal are sometimes considered to be a form of buy-sell agreement. However, a right of first refusal is not, in and of itself, a buy-sell agreement.
How Rights of First Refusal Operate
The typical right of first refusal states the conditions under which shares of a corporation can be sold. Rights of first refusal tend to work along these lines:
- If a shareholder desires to sell his or her shares to a third party and the third party provides a concrete offer, the corporation retains a right of first refusal to purchase the shares at the same price and on the same terms offered to the existing shareholder by the third party. The corporation generally has a period of time, from 30 to 60 days or more, during which to match the third party offer and purchase the subject shares.
- If the corporation does not match the offer within the specified period, many agreements provide what could be called a “right of second refusal” to the other shareholders of the corporation. Such secondary rights are normally offered to the shareholders pro rata to their existing ownership. If one or more shareholders elect not to purchase, the other shareholders can then purchase the extra shares (usually pro rata to remaining ownership). The other shareholders then have a period of time, from 30 to 60 days or more, during which to match the third party offer and purchase the subject shares.
- In order to assure the possibility of a completed transaction, the corporation must have a “last look” opportunity to purchase the shares if the other shareholders do not. The corporation is granted some additional time, perhaps 30 to 60 days or so, to make this final decision.
- If all of the prior rights are refused, then and only then, is the original shareholder allowed to sell his or her shares to the third party — again, at the price and terms shown to the company and other shareholders.
Rights of First Refusal and Family Businesses
Rights of first refusal are used to maintain stock within specified groups of shareholders, and particularly with family businesses. They are said to have a “chilling effect” on the ability to transfer stock:
Many object to the concept of a right of first refusal on the grounds that it may have a chilling effect on would-be purchasers. The third-party offeror’s enthusiasm is repressed by not knowing whether its deal will be consummated. Third-party offerors also resist acting as the stalking horse to set the price that someone else can match.
Rights of first refusal are designed to resolve two issues from the viewpoint of a corporation and remaining shareholders. Rights of first refusal:
- Discourage third parties from making offers to buy shares from individual shareholders.
- Give the corporation control over the inclusion of third parties as new shareholders.
If a third party offer is low relative to intrinsic value as perceived by the corporation and the other shareholders, the third party will know (or likely believe) that there is a high likelihood that the offer will be matched by either the corporation or the other shareholders, so there is little opportunity to purchase shares at a bargain price.
If a third party offer is at the level of perceived intrinsic value, the corporation and/or the shareholders are likely to purchase the shares if there is any likelihood that they do not want to be in business with the third party.
Additionally, if the third party offer is in excess of perceived intrinsic value and the corporation does allow the third party as a shareholder, the third party almost certainly knows that he or she is paying more than either the corporation or any of its shareholders believed the shares to be worth.
Finally, to assure a continuation of their chilling effects, most rights of first refusal require that any successful third party purchaser agree to become subject to the same (restrictive) agreement.
Agreements including rights of first refusals are often written so that existing shareholders can sell shares to each other (often requiring that such transactions do not impact control of the entity), or transfer shares within their families. These provisions provide flexibility for shareholders who are “on the team,” so to speak. As one commentator notes:
…In a family-owned business context, sales or other transfers to family members, for estate planning or other personal motivation reasons, would be excluded from these requirements. This exclusion would therefore enable the family-owned shareholdings to remain in the family.
In closely held businesses, with perhaps more than a single family involved, the same types of provisions can enable the various groups to maintain relative ownership.
The Bottom Line
The bottom line about rights of first refusal is that they restrict marketability. Buy-sell agreements provide for marketability under specified terms and conditions upon the occurrence of specified trigger events.
Many corporations have buy-sell agreements which incorporate rights of first refusal. The buy-sell portion of such agreements provides for liquidity for shareholders under the conditions established in the agreement. The right of first refusal then determines the ability of shareholders to transfer their shares up to the point of a trigger event.
Do you have an effective buy-sell agreement? Do you need one? Will the one you have accomplish your desired goals when it is triggered? Is a right of first refusal provision included as part of your buy-sell agreement?
Based on my more than 30 years of experience in dealing with buy-sell agreements and rights of first refusal, yours is the rare exception if there aren’t business and/or valuation issues that need to be clarified. To find out more about the issues, continue to read this blog.
Accelerate the learning process and get Buy-Sell Agreements for Closely Held and Family Business Owners. I recommend getting multiple copies of good books to share with your spouse, your fellow shareholders, or friends you know who can benefit from the messages in them.
And keep reading this blog (and share it with your friends, advisers, and colleagues), because we’ll be providing fresh insights as we continue to explore buy-sell agreements and how to make them work.