Rights of first refusal (ROFRs) are not the same as buy-sell agreements.
They may seem to operate like a buy-sell agreement, in that they provide procedures related to possible future stock transactions. But ROFRs do not assure that transactions will occur.
Rights of first refusal restrict the marketability of shares during the period of time shareholders own stock in a corporation. They restrict marketability because they discourage third parties from engaging in the time, effort, and expense of due diligence regarding investments.
In addition, 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.
Rights of first refusal are designed to do several things from the viewpoint of a corporation and remaining shareholders:
- First, they discourage third parties from making offers to buy shares from individual shareholders.
- They also 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, 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 refusal, are often written so that 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.
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.
For more information on rights of first refusal, see this previous post.
Do you have an effective buy-sell agreement? Will it accomplish your desired goals when it is triggered? For information, from a business valuation perspective, to enhance, improve, and help ensure that your buy-sell agreement (or those of your clients) provide reasonable and workable solutions, check out the book Buy-Sell Agreements for Closely Held and Family Business Owners.