Understanding Rights of First Refusal: A Guide for Employees with Equity Compensation

Rights of First Refusal (ROFR) are critical provisions that affect how employees can transfer or sell their equity. This comprehensive guide explains ROFR, its implications, and how to navigate these provisions effectively.

What is a Right of First Refusal?

A Right of First Refusal is a contractual right that gives the company (and sometimes other shareholders) the opportunity to purchase shares before they can be sold to a third party. This right typically applies to:

• Stock acquired through option exercises
• Restricted stock purchases
• Any other company share ownership

How ROFR Works: Step-by-Step Process

Notice Requirements: When an employee receives a third-party offer:

Written Notice Requirements:

• Proposed buyer's identity
• Purchase price
• Payment terms
• Other material conditions

Timing Requirements:

• Usually 30-45 days notice
• Can vary by company
• Clock starts upon proper notice

Example Notice Format: Notice of Proposed Transfer under ROFR

• Date: [Date]
• To: [Company Name]
• From: [Employee Name]

Details of Proposed Transfer:

• Number of Shares: 10,000
• Price per Share: $25
• Total Consideration: $250,000
• Proposed Buyer: XYZ Investment Fund
• Payment Terms: Cash at closing
• Proposed Closing Date: [Date]

Company Response Period

Typical Timeline:

• Day 1-15: Company evaluation period
• Day 15-30: Company decision
• Day 30-45: Closing period if company exercises

Company Options:

Exercise ROFR

• Match third-party terms
• Purchase all or portion
• Set closing timeline

Waive ROFR

• Allow third-party sale
• May have conditions
• Time limit for completion

Real-World Scenarios

Scenario 1: Simple Cash Offer

Situation:

• Employee has 20,000 vested shares
• Receives offer for $15/share
• All-cash transaction

Timeline:

• Day 0: Notice submitted
• Day 20: Company exercises ROFR
• Day 35: Transaction closes

Financial Impact:

• Same proceeds ($300,000)
• Different buyer (company vs. third party)
• Potentially faster closing

Scenario 2: Complex Terms

Situation:

• 50,000 shares
• Offer includes:
  • $10/share cash
  • $5/share earnout
  • Strategic partnership terms

ROFR Complications:

• Company must match all material terms
• May need to provide equivalent value
• Could lead to negotiations

Scenario 3: Partial Exercise

Original Offer:

• 100,000 shares
• $20/share
• Single buyer

Company Response:

• Exercises ROFR on 60,000 shares
• Waives rights on 40,000 shares
• Same price terms

Result:

• Split transaction
• Multiple closings
• Additional complexity

Key ROFR Provisions to Understand

Scope of Rights

Common Coverage:

• Voluntary transfers
• Involuntary transfers
• Pledges and encumbrances
• Estate planning transfers

Exceptions Often Include:

• Family transfers
• Charitable donations
• Estate transfers
• Small percentage transfers

Exercise Mechanics

Price Matching Requirements:

• Exact same terms
• Equivalent value
• Payment timing

Example Price Match:

Original Offer:

• $1M total price
• $800K cash
• $200K note

Company Match Options:

• Identical terms
• All cash at present value
• Modified payment schedule

Time Periods

Critical Deadlines:

• Notice period
• Exercise period
• Closing period
• Waiver expiration

Example Timeline:

• Day 0: Notice delivered
• Day 30: ROFR exercise deadline
• Day 60: Closing deadline
• Day 90: Waiver expiration

Impact on Sale Strategies

Finding Buyers

Considerations:

• Buyer awareness of ROFR
• Price negotiation impact
• Timeline expectations

Strategy Example:

• Identify multiple buyers
• Obtain written offers
• Select best terms
• Factor in ROFR probability

Negotiating Terms

Key Points:

• Price structure
• Non-price terms
• Timing considerations
• Break-up provisions

Example Term Sheet:

Purchase Terms:

• Shares: 25,000
• Price: $30/share
• Deposit: 5%
• ROFR Period: 45 days
• Break-up Fee: $50,000

Transaction Planning

Timeline Management:

• ROFR notice preparation
• Response period
• Closing coordination
• Back-up plans

Tax Considerations

Timing Issues

Hold Period Impact:

• ROFR exercise timing
• Capital gains qualification
• Tax year planning

Example Calculation:

• Exercise date: January 1, 2023
• ROFR notice: December 1, 2023
• Closing: January 15, 2024
• Tax year implications

Structure Considerations

Tax Planning Opportunities:

• Payment timing
• Installment sale treatment
• State tax implications

Example Structure:

• Total value: $500,000
• Year 1 payment: $300,000
• Year 2 payment: $200,000
• Tax impact spread

Best Practices

Documentation

Essential Records:

• Equity agreements
• ROFR notices
• Company communications
• Transaction documents

Document Checklist:

• Original grant documents
• Vesting records
• Transfer notices
• Tax records

Common Mistakes to Avoid

Process Errors

Frequent Issues:

• Incomplete notices
• Missed deadlines
• Poor documentation
• Inadequate terms

Prevention Steps:

• Use notice templates
• Calendar all deadlines
• Maintain communication records
• Verify all terms

Strategic Errors

Planning Mistakes:

• Ignoring ROFR in negotiations
• Poor timing choices
• Inadequate preparation
• Missing market opportunities

Action Items

Preparation Phase

Documentation Review:

• Locate all agreements
• Understand terms
• Identify requirements
• Prepare templates

Transaction Phase

Execution Steps:

• Buyer identification
• Term negotiation
• Notice preparation
• Response management
• Closing coordination

Understanding and properly managing ROFR provisions is crucial for successful equity transactions. Careful planning, proper documentation, and professional guidance can help navigate these requirements effectively while maximizing transaction value and minimizing complications.