Right of first refusal is a contractual right that provides its holder the choice to enter into a business transaction with the owner of something— according to the specified terms— before the owner is enabled to enter into that transaction with a third party.
Or in simpler words, the right of first refusal is a contractual right to enter into a business transaction with an individual or a firm before anyone else can. Right of first refusal is also referred to as ROFR and first right of refusal.
If the party who possesses this right refuses to enter into a transaction, the debtor is free to entertain other offers. This clause is widespread and popular among the leases of real estate as it provides them the preference of choosing the properties in which they wish to reside. Nevertheless, it may bound what the owner could have received from the involved and interested parties competing for the said property.
How Does the Right of First Refusal Work?
In the rights of first refusal, the holder has the right, but not the obligation, to enter into a transaction. These transactions usually tend to involve an asset. Right of first refusal clauses are akin to options contract as the holder isn’t obliged to enter into the agreement. The person who possesses this right has the chance to create an agreement or a contract concerning an asset before others can.
The one who holds the rights may opt to not make the expenditure and commitment right away, instead, they might prefer to get involved at a later point in the future. And with the possession of the right of first refusal, they are allowed to do so. Generally, rights of first refusal are demanded by entities or business firms who desire to see how a business or an opportunity will turn out in near future.
Generally, the right of first refusal agreements is limited by time. Once the predetermined period expires, the seller is permitted and free to pursue other buyers. Right of first refusal clauses can be constructed as per the holder’s wishes to create variations of the typical agreement. As mentioned before, the parties can make changes here and there, for instance, they can allow a third party which is nominated by the buyer to make the purchase or something as simple as specifying how long the right is valid.
Rational to Incorporate Right of First Refusal in SHA
It is vital to call the term ROFR the ‘last look provision’ as it offers the right to the remaining stockholders to buy the stake in case of any sale of the shares by any of the investor who has invested his/her capital in the joint venture and he/she wants to exit. The right of first refusal clause can also be used in different types of agreements as an exit option for the remaining stockholders. Thus, ROFR becomes a must right in the contract from the investor’s perspective and it also gives benefit to the rest of the shareholders.
The rational to consider the Right of first refusal as a clause in a commercial contract is stated below:
- The right of first refusal clause helps to control the process of welcoming a new stockholder while also controlling the liquidity of the selling shareholder. It also provides a cushion to the remaining non-selling partners in a stockholder agreement.
- During the event of the sale of shares by the majority partner, the interest of the minority shouldn’t be condensed. ROFR gives a perfect balance of power between the shareholders as it considers and benefits the minor shareholders too.
- The ROFR can be conscripted and revised as predetermined between the parties to the agreement and should be incorporated in accordance as stated by the investors.
- It helps the buyer to hold the right to buy the shares later. Whenever the promoter of the company offers the right of first refusal clause to the investor/buyer, it is also benefiting from the act as the ROFR clause plays as a better negotiation tool and attracts possible investors. The naïve investors presume that the promoter cares about their investment and is willing to protect their investment.
- In cases like startup funding, the existing investors block the incentive of an external investor for the investment by applying the right of first refusal.
- It could also provide a fast and botherless choice to the shareholder who is intending to sell his shares and exit from the business after taking his profit and investment.
Pros and Cons of Right of First Refusal
A right of first refusal is akin to an insurance policy for the entitled party. It reassures them that they will not lose rights to an asset they have their eyes set on. For instance, a commercial tenant may prefer to lease a particular location, nevertheless, he might even buy the premises lest being ejected if the property is sold to a new owner.
In cases similar to this, the tenant would prefer negotiating the clause of the right of the first refusal incorporated into his/her lease. In this way, if the leasing becomes impossible, he would at least still have the option to buy the said property way before the others have the chance to seize the opportunity.
On the other hand, the right of first refusal is a deterrent for the one who owns the property since it bounds him/her from negotiating with multiple other buyers, who in a bidding war could easily raise the bar high for the price of the concerned property.
As seen in the example above, the landlord might have a very difficult time attracting possible buyers if he/she knows that the current tenant is always the first one in the line to buy his/her property. Nonetheless, if attracting the right tenant requires a right of first refusal, the owner of the property still might do it.
In the practical business world, the rights of first refusal are frequently seen in joint venture circumstances. The partners in a joint venture usually own the right of first refusal on purchasing out the shares held by the other partners who choose to leave the venture. Likewise, a right of the first offer provides the non-selling stockholders in a stockholder agreement the right to buy the shares of selling shareholders before they are ever offered to the public.
Rights of first refusal are a common characteristic in many other areas from sports to real estate and entertainment. For instance, a publishing house might ask for the right of first refusal on the upcoming books by a new author.
Right of First Offer
The right of the first offer is often caused when a person who owns a property decides to sell or lease an asset of his/her. This right provides the property holder the first chance to buy or put a lease on the asset before it is even offered to a third party. It is up to the property owner whether or not to deny the holder’s offer, but they must give them at least a chance to buy or lease first.
This could also be referred to as the ‘right to the first negotiation’. This right simply allows the holder to make the first offer on the asset if the property owner ever decides to sell or lease his asset. The owner has to extend the contractual consideration of giving the holder the first bid if they don’t want to accept the holder’s offer. Also keep in mind that owners are not obligated to accept the offer, similar to what we saw in the right of the first refusal.
The Difference between Right of First Refusal (ROFR) and Right of First Offer (ROFO)
The right of first refusal clauses is usually constructed to expire at a predetermined date, while the right of first offer clauses is not. Right of first offer lids the property price at terms set by a triggering event (which usually tends to be a third party offering to buy or lease the property from the owner). Whereas, the right of the first offer provides the property holder an opportunity to lease or buy the said property before the owner even lists it overtly. This doesn’t set a price and it generally raises the value of the property.
The risk is noticeable in each party with market volatility and the value of property in mind when the term of the right of first refusal clause is longer.
That was all about Right of First Refusal. It is nothing but the right to enter into a deal with utmost priority. It is indeed an important concept and if you are running a business, you need to be aware of it. We hope that this article has served its purpose and has given you enough insights about the same!
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